The Debt Service Coverage Ratio (DSC) is a term often used by bankers and others when discussing investment real estate. In my experience, DSC is one of those items often examined by bankers when evaluating the potential of an income property. Thus, it is something that real estate investors should understand.
What is a Debt Service Coverage Ratio?
DSC is a ratio of income to principal and interest payments. It measures cash flow. A DSC of 1 means that there is roughly equal amounts or money coming in and going out. A number greater than 1, like 1.5, would mean that you have positive cash flow. While a number below 1 would mean the property has negative cash flow.
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How is Debt Service Coverage Ratio Calculated?
When calculating DSC each property is often looked at individually. But, one can lump everything together to get an overall picture of the investor and their business.
DSC is calculated as follows:
DSC = Net Operating Income (NOI) / Principal and Interest Payments
Let’s do a quick example.
A property’s gross monthly rental income is $1500. To calculate NOI, subtract out expenses and vacancy credits along with taxes and insurance. For simplicity, let’s say each of these equal 10% of gross income or $150 for a total of $600. Thus, NOI is $1,500 – $600 or $900.
The monthly principal and interest payments are $600.
The DSC is therefore $900 / $600 or 1.5.
Here’s Why it Matters
The above example shows that the property has excellent cash flow. A ratio of 1.25 or higher demonstrates that the property will be generating enough cash to handle expenses, some potential emergencies and still have enough left over to pay the debt service (mortgage). Essentially, it demonstrates that the property is a good risk from a cash flow standpoint. It tells the banker that there will be money available to repay the loan, even after all other expenses.
Here is Where You Should Use It:
Calculate the DSC ratio for your existing properties and include it in your info packet when shopping around for commercial loans. This will demonstrate that you have properly structured your business and have cash coming in to handle your expenses.
Also, calculate the ratio for your bank when approaching them on financing a potential purchase. It is another way to help them say “yes” to your loan request by showing that the purchase is a good risk.
To Sum Up
Using the DSC ratio demonstrates to bankers and others that you just might know what you are talking about when it comes to real estate investing. It puts you on their level because you are speaking their language. It may just be what you need for the banker to tell you yes.