What Is a Debt Service Coverage Ratio?

Debt service is the total of principal and interest due in a year. The OCC’s handbook for bank examiners says the DSCR, calculated by dividing net operating income (NOI) by annual debt service requirements, measures the borrower’s ability to service its debt. Its glossary states the numerator more broadly, as cash flow or NOI.

• DSCR = income available for debt / annual debt service
• Below 1.0: income does not cover the payments.
• At 1.0: income exactly covers the payments, leaving no cushion.
• Above 1.0: income covers the payments, with something to spare.

Here is a hypothetical, for illustration, for an investor-owned building. NOI is $200,000 and annual debt service is $160,000. The DSCR is $200,000 / $160,000 = 1.25, written 1.25x. Income is 25 percent more than the payments. All figures in this guide are invented and are not market or lender data.

An owner-occupied building may have little or no outside rent, so the lender has to look elsewhere for repayment. The handbook says that for owner-occupied properties the primary source of repayment is usually the cash flow generated by the occupying business, and that sound analysis typically considers the ability of the occupying business, the borrower and any guarantors to repay.

It also says cash flows should be assessed on a global basis, and that this analysis can require integrating business financial statements, tax returns and Schedule K-1 forms. The analysis should consider cash flows from all activities, and actual or contingent liabilities. In plain terms, a lender may look past your building, and past your company’s income statement, to your other debts and to the owners behind the company.

Each lender has its own formula for the numerator. Common questions include what it adds back to earnings, how it treats owner distributions, and whether it credits the rent you will stop paying when you move out. Ask your lender to show you its calculation rather than guessing.

Here is a second hypothetical, for illustration, assuming a lender that adds back the rent the company will stop paying. Your lender’s method may differ.

• Pre-tax profit: $150,000
• Add depreciation and amortization: $50,000
• Add existing interest expense: $40,000
• Add current rent, which ends when the company moves: $150,000
• Cash flow available for debt: $390,000
• Debt service on existing loans: $60,000
• Debt service on the new building loan: $240,000
• Total debt service: $300,000

The DSCR is $390,000 / $300,000 = 1.30x. Now test a bad year. If profit falls by $60,000, cash flow is $330,000, and the ratio falls to $330,000 / $300,000 = 1.10x. The building has not changed, but the cushion has shrunk by two-thirds, from $90,000 to $30,000.

The ratio also works backward to size a loan. If a lender in this example required 1.25x, total debt service could be no more than $390,000 / 1.25 = $312,000. Taking out $60,000 for existing loans leaves $252,000 a year for the building loan. Because the formula sets the payment, a shorter amortization or a higher rate means less loan for the same income.

This guide does not quote a minimum. Each lender sets its own standard, and it can differ by program, property and borrower. The OCC handbook sets out considerations rather than a number:

• The appropriate ratio should consider the amortization period and the expected volatility of the cash flow.
• A lower ratio may be a prudent trade-off for a shorter amortization, or for stable cash flows such as long-term net leases to highly creditworthy tenants.
• Properties with volatile cash flows, such as hotels or owner-occupants with uneven earnings, may warrant a higher ratio.
• Calculations for loan covenants may differ from the ratio used in underwriting, and the definitions of income and expense should be clear.

The handbook guides bank examiners and does not set rules for your particular loan. Ask each lender directly, and get the answer in writing in its term sheet.

Reaching the minimum at closing is not the same as being comfortable. Decide what coverage you need in a bad year, not just what the lender needs in a normal one.

1. Ask your CPA to prepare clean financial statements and identify one-time expenses you can document.
2. Ask lenders how they calculate the ratio, and run your numbers using each method.
3. Pay down or refinance other debts where that lowers annual payments more than it hurts your cash position.
4. Compare a lower price, a larger down payment and a longer amortization, since each lowers the annual payment.
5. Consider a different program. The SBA’s program page lists 10-, 20- and 25-year terms for 504 loans. Terms can change, and eligibility rules apply.
6. Model the operating costs of the building as well. Taxes, insurance and repairs are real claims on cash even if a lender’s formula treats them differently.

TAG is a broker and not a lender, so we do not underwrite loans. What Tenant Advisory Group can do is help you pick a building and negotiate a price that leaves your coverage intact, and bring the facts about the property to the lender you choose.

DSCR does not always end at closing. A loan agreement may require the borrower to maintain a minimum ratio and report on it periodically. The OCC handbook notes that when loan documents contain coverage covenants, the definitions of income and expenses should be clearly defined.

• ✓Is there a coverage covenant, and at what level?
• ✓Is it tested at the company, the holding company or across all guarantors?
• ✓How often is it tested, and over which period?
• ✓What happens if we miss it: a fee, a cash deposit, or a default?
• ✓Does the definition match the one used when the loan was approved?

Have your attorney and CPA read this section before you sign. A company that loses a large customer could stay current on every payment and still breach a covenant.