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Why is a Debt Service Coverage Ratio (DSCR) Needed?

DSCR, or Debt Service Coverage Ratio, is a calculation used typically in commercial lending transactions involving real estate. It measures a property’s cash flow compared to its current debt obligations. The evaluation of a company’s DSCR gives the lender a general idea on whether a business can pay a loan back on time and with interest. The higher the DSCR number, the more likely the business will be accepted for the loan.

 

The Basics of DSCR

 

Why is it needed?
The DSCR tells the lender that the net income is adequate to support the loan payments. A business owner would not want to take out a loan on an income property or business if the net income was just enough to make the loan payments. A healthy margin is needed to create a profit. The lender needs to see this, as well. The margin of cash left over after loan payments are made is the debt service coverage ratio. The higher the ratio number, the lower the risk is for the lender.

 

How is DSCR calculated?

The formula for calculating DSCR is:

 

DSCR = Annual net operating income/annual debt payments

 

The net operating income is derived from the net income + depreciation + interest expenses + other non-cash items.

 

The debt payments formula is: principle repayment + interest payments + lease payments.

 

How can I increase my DSCR ratio?

A business can increase its DSCR ratio by taking action to increase the net operating income. Here are just a couple of ways to do so:

  • Decrease expenses – Re-negotiate with vendors to reach a better deal.
  • Increase efficiencies – Look to see if there are any redundancies that can be eliminated to reduce costs.
  • Pay off existing debt – Any debt that can be eliminated will no longer be part of the DSCR equation.
  • Reduce the amount of the loan request – This will automatically reduce the DSCR number.

 

Do you have more questions regarding the DSCR? At Fidelity Mortgage Lenders, we’re here to help. Contact Peter directly on PSteigleder@FidelityCA.com or give him a call on 818.422.8879.

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