Debt Service Coverage Ratios Explained
DSCR, or debt service coverage ratio, is a metric used in commercial and multifamily real estate to calculate a project’s cash flow compared to its expenses. DSCR is one of the primary metrics used to underwrite commercial and multifamily real estate loans, as well as commercial leases.
DSCR can also be used to calculate residential loans or loans for corporations or other entities. The lower the DSCR, the riskier the deal, as there is less cash margin to pay off a loan or other monthly or annual expenses. A DSCR of 1 means that a property’s cash flow is exactly meeting its expenses, while a DSCR of above 1 means that a property has excess cash flow after meeting its expenses.
What is the Formula for DSCR?
The formula for DSCR is:
Net Operating Income (NOI) / Total Debt Service
For instance, if an apartment building had an NOI of $20,000/month and total debt service of $15,000/month, the DSCR would be:
$20,000 / $15,000 = 1.33x DSCR
In many cases, an “x” is used after DSCR to connotate the fact that it is a variable. It does not change the meaning of the term in any way.
What NOI Expenses Are Used To Calculate DSCR?
Common expenses that compromise a properties net operating income (NOI) and are used to calculate DSCR include:
Mortgage payments, including interest (unless when tax-deductible)
Property management fees
Additional maintenance fees
Property taxes
Required replacement reserves
Other operating expenses
What Are Acceptable DSCRs for Various Property Types?
As we mentioned earlier, all else being held equal, lower DSCRs mean a deal is riskier, while a higher DSCR means that a deal is generally less risky. Therefore, lenders and investors will want to see higher DSCRs for properties that are inherently riskier. Average acceptable DSCRs vary by lender, loan type, and property type. Average minimum acceptable DSCRs may include:
Multifamily and Apartment Properties: 1.20-1.25x min. DSCR
Retail and Office: 1.25-1.35x min. DSCR
Hotels and Hospitality Properties: 1.40-1.50x min DSCR
Mobile Home Parks: 1.25-1.35x min. DSCR
Senior Living: 1.40-1.45x min DSCR (higher for nursing homes and memory care facilities, lower for assisted living and independent living properties)
As one might expect, more exotic property types, which are considered riskier, will generally require higher DSCRs to be approved for a loan. Examples of unique and exotic property types include parking lots, marinas, and recreational properties, like theme parks or golf courses.
Unique DSCR Requirements for Affordable Properties
Some specialized loan programs, such as HUD multifamily loans and Fannie Mae multifamily loans, provide reduced DSCR requirements for affordable properties. For example, the HUD 221(d)(4) loan program for the construction or substantial rehabilitation of multifamily properties requires DSCRs of lower than 1.20x for affordable property types. Affordable types with lower DSCR requirements include:
HUD 221(d)(4) Multifamily Construction or Substantial Rehab Loans:
Market-Rate: 1.20x min. DSCR
Affordable: 1.15x min. DSCR
LIHTC: 1.11x min. DSCR
HUD 223(f) Multifamily Purchase or Refinance Loans:
Market-Rate: 1.20x min. DSCR
Affordable: 1.15x min. DSCR
LIHTC: 1.11x min. DSCR
Fannie Mae Affordable Housing Loans: 1.15x min. DSCR
Freddie Mac Section 8 Housing Loans: 1.15x min. DSCR
Lower DSCR Loans for Commerical Properties
In addition to using DSCR as a major metric for qualifying multifamily, commercial, and residential loans, some single-family and multifamily lenders offer high-risk, non-QM loans that they refer to as “DSCR loans”.
In some cases, lenders permit DSCRs of as low as 0.75x for these “DSCR loans”. These loans may require larger down payments, sometimes as much as 40%, placing them at LTVs of 60% or lower. In addition, they may require reserves of 12 months or more in order to provide the lender with an additional degree of security.