DSCR—or debt service coverage ratio—is a calculation used by lenders to determine whether a potential borrower has enough income to cover their monthly debt payments. The higher the DSCR, the more likely it is that a borrower will be able to make their loan payments on time. Here’s what you need to know about DSCR if you’re planning to apply for a commercial real estate loan:
What is Debt Service Coverage Ratio (DSCR)?
The debt service coverage ratio is a financial ratio that can be used to measure a company’s ability to repay its debts. The ratio is calculated by dividing a company’s operating income by its total debt payments.
A higher DSCR indicates that a company has more income available to make its debt payments, while a lower DSCR indicates that a company has less income available for debt service.
DSCR is just one factor lenders consider when evaluating a loan application—they’ll also look at your business’ credit history, collateral, and overall financial health. But a strong DSCR can give you an edge when competing for financing.
To calculate DSCR, divide your company’s annual net operating income (its total revenue minus operating expenses) by its total debt service (including interest and principal).
Use this formula to calculate DSCR:
The net operating income (NOI) is the difference between revenue and operating expenses. Revenue includes rental income, as well as other sources like parking fees, service charges, vending machines, and laundry machines. Operating expenses include all indispensable expenses. This may include property management fees, insurance, utilities, property taxes, and the cost of repairs and maintenance.
Total debt payments include all of a company’s interest payments and principal repayments on outstanding debt.
Take, for example, a company with an NOI of $1 million and total debt service of $500,000. The company’s DSCR would be 2.0 ($1 million/$500,000), indicating that the company has enough income to cover its debt payments twice over.
What Is a Good DSCR Ratio?
A DSCR of 1.2 or higher is generally considered the minimum accepted by lenders, indicating that the borrower has enough income to comfortably make its debt payments. For that reason, lenders typically prefer a DSCR of 1.25 or higher for loans backed by commercial real estate. For unsecured loans, such as business lines of credit, lenders usually prefer a DSCR above 1.5.
On the other hand, a DSCR below 1 means a company doesn’t have enough income to cover its debt payments and may default on its loan. In this case, a lender will likely tell the borrower that they can’t afford the loan based on their current annual income. Alternatively, the lender may look for other assets or income sources that can be used to support the loan.
How to Improve Your DSCR
Improving your DSCR is a good way to make your business more attractive to lenders and improve your chances of getting approved for financing. If your DSCR is below 1, there are a few things you can do to improve your chances of getting approved for a loan:
- Reduce your expenses. Look for ways to cut costs and increase efficiency to increase your net operating income.
- Bring in more revenue. Find new customers or offer new products and services that will increase your NOI and, therefore, your DSCR.
- Refinance your debt. Pay off existing debts using a new loan with more favorable terms to lower your monthly payments.
- Find a co-signer. Ask someone with good credit to guarantee your loan by serving as co-signer.
Consider a small business owner who wants to take out a loan to expand their company.
They’ve been in business for two years and have generated $200,000 in annual revenue. The business’ expenses totaled $150,000 last year, and the business currently has $50,000 in annual debt service.
DSCR = ($200,000 revenue – $150,000 expenses) / $50,000 debt service
Based on these numbers, the business’ DSCR would be 1.33, which is a strong ratio. This means that the business has enough income to cover its debt payments and then some. As a result, the business is more likely to get approved for a loan.
Interest Coverage Ratio vs. DSCR
While DSCR is the most commonly used ratio to assess a company’s ability to repay its debts, it’s not the only one. The interest coverage ratio (ICR) is another financial ratio that can be used for this purpose.
The ICR measures a company’s ability to make its interest payments on time. It’s calculated by dividing a company’s operating income by its interest expenses.
Like DSCR, a higher ICR indicates that a company has more income available to make its debt payments, while a lower ICR indicates that a company has less income available to make its debt payments.
The main difference between the two ratios is that DSCR includes all of a company’s debt payments (interest and principal), while ICR only includes interest payments.
For this reason, DSCR is generally seen as a more comprehensive measure of a company’s ability to repay its debts. However, ICR can be a useful metric for companies with high levels of debt, as it provides a more detailed picture of a company’s ability to make its interest payments on time.
DSCR Loans Frequently Asked Questions (FAQs)
Should DSCR be high or low?
A company’s DSCR should be high enough to cover its debts comfortably. A ratio of 1 or higher is generally considered strong, while a ratio below 1 means that a company doesn’t have enough income to cover its debt payments and may default on its loan. More specifically, lenders typically require a DSCR of 1.25 or higher for loans backed by commercial real estate. For unsecured loans, such as business lines of credit, lenders usually prefer a DSCR above 1.5.
What does DSCR in loans mean?
DSCR in loans usually refers to the minimum DSCR that a company must have in order to be approved for a loan. For example, a lender may require a minimum DSCR of 1.25 for loans backed by commercial real estate.
Why is the DSCR important?
The DSCR is important because it’s one of the key financial ratios that lenders look at when assessing a company’s creditworthiness. DSCR helps financial institutions determine whether a property generates enough income to cover its debt obligations and, therefore, whether a property owner can afford to cover the monthly debt service. Based on this information, DSCR signals how much risk a loan poses to a lender.