Debt Service Coverage Ratio (DSC) – What it is and Why it Matters For You!

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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.

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.

Photo:swisscan

About Author

Kevin Perk

Kevin Perk is co-founder of Kevron Properties, LLC with his wife Terron and has been involved in real estate investing for 10 years. Kevin invests in and manages rental properties in Memphis, TN and is a past president and vice-president of the local REIA group, the Memphis Investors Group.

21 Comments

  1. Kevin –

    This is an important topic, and I’m glad to see you discussing it here.

    I make a big deal about DCR when I teach real estae investment analysis to my grad students at Columbia, and I insist that it should be part of every property pro forma that they create. I try to underscore at least two key points about it’s importance:

    First, if you trying to obtain financing, you need to know your lender’s underwriting requirements. What is the minimum DCR the lender will accept. It used to be that 1.20 was typical, but now we see 1.25 or even higher (sometimes a good deal higher, depending on the property type). If you can’t show that the property will perform with a DCR that meets their requirements, then you shouldn’t be walking into the lender’s office at all. If you do, you’re still not going to get the loan, but you are probably going to damage your credibility (as in, “Why is this guy asking for a loan that he should know is not going to fly? Must be an amateur.”)

    A second reason an investor should always perform the DCR calculation is so he or she will understand just how much wiggle room exists in their cash flow. I always tell people that they are more likely to encounter unexpected expenses rather than unexpected income from their property, so it’s essential for you — as well as the lender — to know that you have enough slack in your NOI projections to be confident that you can cover the debt.

        • Kevin Perk

          Kris,

          I wish I could do triple net leases with my residential tenants. It sure would make my life easier.

          As an FYI, triple net leases are generally found in commercial developments (think Target or Amazon warehouse space). With a triple net lease, the tenant is responsible for all insurance, repairs, taxes, and whatever else happens. The landlord just collects the rent. Nice!

          Thanks for reading and commenting,

          Kevin

    • Kevin Perk

      Frank,

      Great advice and awesome follow up to the article.

      I to have witnessed banks becoming more and more conservative demanding high DSC ratios of 1.25 or more.

      Plus, your advice is spot on regarding knowing your banks terms beforehand. Don’t force the bank to say “No” bring them a deal that works for them. Everyone looks better that way.

      Thanks for reading and posting,

      Kevin

  2. This is another great tool for judging where you are with your investments. My P/I payment equals roughly 25% of my gross rental income, and using the 50% rule, it gives me a DSC of about 2. And my LTV is under 50% so I am comfortable with my investments.
    Thank you for a good article.

  3. Maybe, we are simply too conservative when evaluating properties for purchase, but we expect a debt coverage ratio of 1.5 or better based on current revenues or, if we feel the building is severally under-performing, 1.5 times the rent roll we are comfortably confident we can extract from the building.

    Our best thus far has been a duplex with a debt-coverage ratio of 2.8 … it makes me smile 🙂

  4. Great post and comments all. One thing to add is that Debt Service Coverage Ratio is variously referred to as DCR, DSC and DSCR and in the lingo the question asked is: Does it debt cover? They all refer to the same ratio and along with LTV and BER are used by lenders to quantify their risk in making a loan.

    BER or Break Even Ratio measures one of the key margins of safety in an income producing real estate investment (Think Warren Buffett style value investing applied to real estate) and Frank explains it in his ‘What Every Real Estate Investor Needs To Know About Cash Flow book. The title is a true statement.

    A newer one to know if you’re dealing with conduit lenders is Debt Yield, which is the NOI divided by the first mortgage debt service. Essentially it is the Cash on Cash Return that a lender in first position would receive if they foreclosed on the property day 1.

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