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Understanding Debt Service Coverage Ratio

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As a commercial finance consultant I speak with new apartment building investors on a daily basis; typically, here is how the conversation unfolds:

Investor: Hello Ted, my name is “first time apartment building investor” and I am calling because I was visiting your website and was interested in the loan program you are offering for multi-family properties.

Me: Great, tell me about the apartment building you are purchasing.

Investor: Well, I found this great 38 unit apartment building in Austin, Texas. My realtor told me that the gross income from the property is around $500,000.00 and the taxes are about $15,000.00. The asking price is $5,000,000.00. I am willing to put down 20% of my own money and I need a loan right away because the realtor said there are other serious buyers looking at the property. What do I need to get a loan on this building?

Me: Have you figured out what the DSCR for the property?

Investor: The what?

Debt Service Coverage Ratio Definition

The Debt Service Coverage Ratio is the number that banks look at to determine if the apartment building will pay for the property’s annual expenses and mortgage payments. DSCR is figured by dividing the (NOI) by the annual debt service of the property.

This is where I gently advise my potential client to perform more due diligence on the property by obtaining the income and expenses on the property for the past few years so that we can determine exactly what the net operating income is.

Here are how the property financials break down:

Gross Rents $500,000
Annual Gross Revenue $500,000
Minus 5% Vacancy Rate $25,000
Actual Gross Income $475,000
Real Estate Taxes $7,500
Insurance $2,500
Maintenance $2,500
Exterminator Service $2,500
Up Keep $2,500
Utilities $2,500
Off Site Management Fee 5% $25,000
Replacement Reserves
$200 Per Unit X 38 Units $7,500
Total Expenses For Operation $52,500
(NOI) Net Operating Income $422,500.00

The net income on this property includes all of the property expenses except for the monthly mortgage payments or “debt service.” The debt service is simply the principal and interest payment on the mortgage paid over a one year period of time.

Loan Amount: $4,000,000
Interest Rate: 7%
30 Year Term
Debt Service = $319,345.20

Calculating the Debt Service Coverage Ratio

To figure out the DSCR, divide the NOI ($422,500.00) by the Debt Service ($319,345.20).

NOI $422,500.00/ Debt Service $319,345.20 = DSCR of 1.32

With a 20% buyer down payment this building has a DSCR of 1.32. This basically means that the building’s income will cover all of its expenses including the loan payments and show a profit. Banks are eager to lend money on a property like this. A DSCR number of 1.0 would indicate that the building is breaking even and a DSCR lower than 1.0 means that the building is losing money. Commercial lenders require that an apartment building have a DSCR of 1.2 or higher.

Armed with this information, the diligent investor is one step ahead of the herd. Preparing an accurate loan package is an essential ingredient to your success as an apartment building investor and calculating the Debt Service Coverage Ratio early on in the process will save you a lot of time and headaches.

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15 Comments

  1. Ted – this is a great article. I am just now looking into getting more into the commercial side of real estate (having just completed by first commercial deal). Super info on this site – thanks,

    Dania

  2. The example states property taxes are $15,000 but in the calculations it changes to $7500 which will skew the results making the deal look better. Be careful when doing calculations and always be conservative.

  3. how did ted arrive @ noi of $475,000 when the rent is $200 per unit times 38 units.I came up with 91,200 noi with the info just presented.

  4. Ted this article was really great about calculating the DSCR on a property I knew what it was, but you made it more crystal clear so far as how to calculate it. Thanks alot Quincy Lewis in Atlanta,GA.

  5. Excellent illustration… all such related articles would render themselves much more valuable and useful by following your lead.;”BUY by the numbers”.

    • Mat – You can start by signing up for BiggerPockets (free) and start reading. Read the articles, blogs, forums, and everything on this blog. Once you do, you won’t need to even ask!

  6. How do you arrive at $319,345.20 as the debt service value.

    Very roughly 4,000,000 / 30 = 133333.33 for principal repayment per year
    Plus 4,000,000 * 0.07 = 280,000 interest payment for first year (will be less, i know)

    Giving roughly 413333.33 to service debt, NOT 319,345.20.

    Key question is, is principal repayment part of calculation?
    Please enlighten me.

  7. Richard Belliveau on

    Hi Peter. Just looked at this and you can see the example is correct using variables like:

    LOAN AMOUNT = $4,000,000.00
    INT RATE = 7%
    TERM = 360 MONTHS

    Then we solve for payments- then multiply that by 12 and you get the annual Princiap and interest payments of $319,345.20.

    I hope this helps and the HP12c is a great financial calculator to solve these equatons.

    The best to you and let me know if you got this.
    Richard

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