Debt service coverage ratio
Also called DSCR, DCR.
The debt service coverage ratio is net operating income divided by annual debt service. A 1.25x means the property produces $1.25 of income for every $1.00 of principal and interest owed, so net operating income could fall by 20 percent before coverage reaches 1.00x and the loan stops being covered.
How it works
DSCR is the central covenant in commercial real estate lending. A minimum ratio is the constraint that most often determines how large a loan can be, and it is typically tested annually or quarterly for the life of the loan, with a breach triggering a cash sweep, a reserve requirement or a default depending on the document.
Minimums vary with asset class and lender. Agency multifamily lending commonly requires 1.25x, though it flexes with leverage and loan structure. Bank and life company lending on commercial property often sits at 1.20x to 1.35x, and higher for single-tenant, hospitality or transitional assets. What matters more than the number is the rate it is tested at: lenders size against a stressed underwriting rate and a stressed amortisation schedule rather than the actual note terms, so the DSCR that governs the loan amount is usually tighter than the one the borrower experiences on day one.
The ratio also moves over the life of a loan for reasons that have nothing to do with the property. A loan with an interest-only period shows a comfortable DSCR that steps down when amortisation begins, and a floating-rate loan's DSCR moves with the index. Both should be modelled forward, not computed once.
Formula
DSCR = net operating income / annual debt service- Annual debt service is principal plus interest for twelve months, not interest alone
- Lenders normally compute NOI with replacement reserves deducted and expenses normalised, which lowers it
- Underwritten DSCR is tested at the lender's stress rate; actual DSCR uses the note rate
Worked example
The sample property. NOI $3,020,000, loan $36,335,000, three years interest only at a 6.35 percent constant, then a thirty-year amortisation schedule.
| Minimum DSCR the lender sized tothe sizing floor, tested at the stress constant; the ongoing covenant on this loan is 1.20x | 1.25x |
|---|---|
| Year-one debt service, interest only | $2,307,272 |
| Year-one DSCR as the borrower experiences it | 1.31x |
| Debt service once the thirty-year schedule begins | $2,713,072 |
| DSCR from year four, NOI held flat | 1.11x |
| The number to report | 1.11x, the minimum across the hold |
Three legitimate answers on one loan. The 1.11x is the one that matters, because that is where the property sits in year four on flat NOI, and it is below a 1.20x covenant. NOI growth is what has to close that gap, and whether it does is a question the model has to answer year by year.
Conventions worth knowing
- Ask which NOI the lender will use. Reserves deducted and taxes reassessed can cut the underwritten NOI by five percent or more before any negotiation.
- Model DSCR for every year of the hold, not just year one. The covenant is tested every year.
The common mistake
Testing coverage only in year one
Year one is often the strongest coverage year of the loan, because it may be interest only and because a value-add property has not yet absorbed its renovation downtime. The covenant does not care. A model that computes DSCR once and reports it as a headline can hide a year-four trough where renovation vacancy peaks and amortisation has begun at the same time. Run the ratio across every year and against the downside case, and look for the minimum rather than the first.
Related terms
- Debt yieldDebt yield is net operating income divided by the loan amount, expressed as a percentage. It measures the return a lender would earn on its loan if it took the property back and operated it, and unlike DSCR it is unaffected by interest rate, amortisation schedule or loan term.
- Loan to valueLoan to value is the loan amount divided by the property's value, expressed as a percentage. It is the most familiar leverage constraint and, on a purchase, is normally tested against the lesser of the appraised value and the purchase price.
- Loan sizingLoan sizing is the process of determining the maximum loan proceeds a property supports. A lender runs three independent tests, a loan-to-value cap, a minimum debt service coverage ratio at a stressed rate, and a minimum debt yield, and lends the lowest of the three.
- Interest-only periodAn interest-only period is a stretch at the start of a loan during which the borrower pays interest and no principal. It raises early cash flow and coverage, and it ends with a step up in debt service that has to be modelled.
- Loan constantThe loan constant is annual debt service divided by the original loan balance, expressed as a percentage. It combines the interest rate and the amortisation schedule into one number, which is what makes it the right rate to compare against a cap rate.
- Break-even occupancyBreak-even occupancy is the occupancy level at which a property's collections exactly cover its operating expenses and debt service, with nothing left over. Below it, the property consumes cash instead of producing it.
Keep reading
Every figure, traced to its source
Altyst computes these in exact decimal arithmetic, not with a language model, and clicking any number shows the formula behind it.