Thursday, September 21, 2023

Understanding Debt Service Coverage – The Backbone of Commercial Real Estate

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Shreya Christina
Shreya has been with for 3 years, writing copy for client websites, blog posts, EDMs and other mediums to engage readers and encourage action. By collaborating with clients, our SEO manager and the wider team, Shreya seeks to understand an audience before creating memorable, persuasive copy.

Phil has been in corporate finance for 37 years. CEO of Global Financial Svc, Global Financial Training ProgramWorldwide Church Funding.

Commercial real estate is one of the largest industries in our country and is much more complex than you may think. In any real estate transaction, there are many components and moving parts that help a sale and purchase and everything that comes with it. Think of negotiations, appraisals, contracts, renovations, etc. Many people are familiar with the general terms and conditions and processes; However, many of them are not aware of what the Accounts Receivable Coverage Ratio (DSCR) is, and how important the role it plays in a commercial real estate transaction.

What is DSCR?

The debt service coverage ratio, simply put, is the ratio between the net operating income of a business or a property and its debts, expenses and liabilities. This helps lenders, financiers and investors measure the ability of a property or business to pay their debt or mortgage from the cash flow generated from the property. DSCR is the same as debt-to-income (DTI) in residential real estate. However, the difference is that in residential the percentage to pay off the debt depends on your personal income, while in commercial cases it is based on the income of the property.

How do we determine what the DSCR is?

For example, let’s say the debt to service ratio for a mortgage is $100,000 per year and the lender wants debt service coverage of 1.2. The lender will want to see the property generate $120,000 after paying their expenses such as taxes, gas, heating, insurance, etc. This ensures that the property generates enough cash to pay its expenses and its mortgage with a cash buffer. The lender wants to make sure that after you take the income from the property minus expenses (gas, electricity, and so on), the remaining balance can pay off the mortgage.

A debt service coverage ratio above 1 indicates that the company is making a profit and is sufficient to pay off its liabilities and debts entirely from cash flow. The higher the ratio, the more debt a company can take on and pay, making it more attractive to lenders. From the above example, a DSCR of 1.2 would indicate that the property earns 120% of what it takes to service the debt. If the DSCR ratio is less than 1, it indicates that the company cannot repay its current debts from net operating income.

How is DSCR applied to commercial real estate?

In commercial real estate, many companies can finance new properties to start or expand a business. The first thing many lenders look at when deciding to finance a property is the DSCR to determine whether they are willing to borrow and if so, how much they are willing to borrow. The DSCR is super important because it helps lenders evaluate how much they can borrow and repay without the company defaulting, and how much mortgage a home can bear. A DSCR can indicate a lot about a company’s management and its efficiencies and inefficiencies.

Many lenders will be looking for a specific DSCR minimum to on-lend, generally at least 1.25. As the DSCR gets higher over time, the borrower can then look to refinance as there is a higher income to pay off a higher debt.

Final Thoughts

All in all, the DSCR is a very important factor when it comes to commercial real estate. Any lender considering financing a property will want a buffer to ensure that their debt is paid and the company can repay it. Unlike residential real estate where personal credit is most important, the DSCR is probably the first number lenders will look at and arguably the most important as it is the determining factor for how much financing a lender is willing to borrow. Business Council is the leading growth and networking organization for entrepreneurs and leaders. Am I eligible?

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