Business Home Loan Analysis: Debt Service Coverage Ratio

The last few articles have discussed some of the criteria and analysis that go into determining the viability of a commercial mortgage loan. We have analyzed how we arrived at the net operating income or NOI of a building. This is key, because it tells us how much the building makes, after expenses. And remember, in a business loan the key is what the building earns. This is why buildings next to each other with the same number of shops and apartments above can be worth two different amounts. Different levels of NOI! We have looked at the capitalization rate or return that a commercial property buyer wants on their investment. We show how this number, together with NOI, can give us an idea of ​​the value of a building.

Debt Service Coverage Ratio or DSCR

Now let’s look at the most important number, the number that will go a long way in determining whether or not a commercial home loan can be financed. It is a number that can reduce the loan amount or even increase it. This number is the Debt Service Coverage Ratio or DSCR. Remember what we said at the beginning in article 1. Commercial mortgage loans are not about LTV, but about DSCR.

DSCR is not a complicated formula, but it will tell us whether the debt service (principal + interest) of a given loan amount at a given interest rate will be adequately covered by the NOI that the building produces. Again? Will the annual NOI divided by the annual debt service coverage of the desired loan result in a DSCR high enough to satisfy the lender? Typically, the minimum DSCR level will be 1.20X or 1.25X depending on the type of property.

Remember that the mortgage rate cannot be higher than the cap rate, or the building will not pay the debt service. Another way of looking at it: You can’t borrow money from Bank 1 at 7% and turn around and invest it in Bank 2 at 6%. This is not a winning proposition, and in terms of commercial mortgages, you won’t get the DSCR you need.

Now let’s take a look at an example. Remember that the calculations are not complicated, but the results are critical to the success or failure of loan financing:

NOI = $ 80,000 Annual Mortgage Expense = $ 65,000

DSCR = $ 80,000 / $ 65,000 = 1.23X, which is fine for certain types of properties

What happens if the NOI goes down or the mortgage expense goes up?

NOI = $ 75,000 Annual Mortgage Expense = $ 68,000

$ 75,000 / $ 68,000 = 1.1X DSCR, which is not a good number.

One way to avoid this is a lower loan amount that will result in a lower mortgage expense. This will require a higher down payment for a purchase or lower income in the event of a refinance.

In any case, the conclusion remains that:

Income-producing property must be able to support itself!

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September 30, 2021