A Debt Service Coverage Ratio (DSCR) is a measure of risk often used by real estate lenders to assess the risk of a particular loan or portfolio of loans. A DSCR measures the ability of a real estate asset to cover its debt service requirement. The calculation is made by dividing the Net Operating Income (NOI) by the amount of the debt service. NOI is defined as the income generated from a real estate asset minus the operating expenses necessary to operate the asset, but before the deduction for debt service, depreciation, and taxes. Debt service is defined as the periodic payment to service the debt.  If an annual NOI is to be used in the calculation, match the debt service by using the annual amount. Let’s take a look at the calculation (where N is the number of loans secured by the asset or portfolio):

A DSCR of 1.19 tells us that the asset’s debt service is being covered with enough income left over to cover an additional 19% of debt service. Notice that the monthly payment of Loan 1 was multiplied by 12 to arrive at an annual amount. The $23,250 of debt service for Loan 2 is already an annual amount.  The NOI was also stated as an annual amount.

Let’s take a look at how DSCR might change over time. The chart below tracks the DSCR of a real estate asset that is secured by two loans. The first position loan is a constant payment with a fixed interest rate and a the second position loan is interest only payable monthly with a variable interest rate floating on Prime with a 5% floor.

Let’s see what we can learn from the chart.

• In the beginning of the year in 2008, the asset was not covering its debt service. There was not quite enough NOI to cover its debt service with a DSCR of about .99.
• As the Prime rate was falling during 2008, it began to better cover its debt service because the debt service on the 2^nd position loan was falling inversely with Prime until the 2^nd position loan hit its interest rate floor of 5%.
• NOI increased between 2008 and 2009 and the DSCR leveled off. It’s now barely covering the debt service with a DSCR of about 1.04.

The question is: Do you know the Debt Service Coverage Ratio for each of your real estate assets and for your entire portfolio of real estate assets? Calculating the DSCR for each of your real estate assets can be time-consuming and the calculation keeps changing over time as your debt balances change and the NOI changes. Fortunately, with loan software you don’t need to be a mathematician or hold an MBA to calculate your own DSCRs. Your loan transactions can be initiated from within the system and automatically imported into your other financial systems. By maintaining current loan balances and current interest rates in the debt management system, you can calculate the DSCRs for each of your assets and portfolio and much, much more at the touch of a button. For more information on loan and asset organization and Portfolio Debt Manager, visit http://www.portfoliodm.com/.

For additional information about this and other topics contact Ledgerwood Associates.