By Venture Mortgage Corporation
What Is A Debt Service/Coverage Ratio, and What Does It Mean For My Commercial Real Estate Portfolio?
Debt Service Coverage Ratio (DSCR) refers to the ratio of Net Operating Income (money left over after the bills are paid) over the amount of debt service (mortgage payment) contributed to a given property. Typically, a lender wants to see a DSCR equal to or greater than 1.25.
Lenders want to see the cushion afforded by the positive DSCR so that if there is a hiccup in the operation of the commercial property, there is room to absorb the blow and still be able to cover the obligation of paying the mortgage. Given our example above, let’s assume the $40,000 debt service represents a loan of $625,000 with a 4% interest rate with a 25 year amortization – and that expenses are normalized and under control. As you can see, with just a small rise in interest rate, the loan looks significantly less appealing to lenders, and can put the borrower in a precarious financial position:
Given the current historically low interest rates, investors are able to fix mortgage payments (debt service) at an extremely low dollar amount, making the DSCR on many of these properties look extremely good (read safe) in the eyes of the lenders.
However, once we consider that property valuations are nearing all time low capitalization rates (cap rate) and that the rental market has seen a now double digit increase in rents, it seems we could be nearing a crisis that will see commercial real estate owners running for the hills on their next round of financing.