How Does a Bank Tell If a Property Makes Enough Money?
Banks want commercial real estate to at least pay for itself and they use a ratio to confirm called the DSCR[/caption]
The ability of a borrower to make loan payments is measured by the debt service coverage ratio (DSCR). The majority of commercial loan applications are evaluated using this metric.
The DSCR is determined by deducting the total debt service payments from the borrower’s net operating income (NOI). The asset’s net operating income is the amount remaining after deducting the cost of running the business from the asset’s total gross income.
If a commercial property has annual operating expenses of $100,000 and generates annual gross income of $500,000, its net operating income (NOI) is $400,000. The DSCR would be determined as follows assuming the annual debt service payments on the property loan amount to $300,000.
DSCR = Net Operating Income / Total Debt Service Payments = $400,000 / $300,000 = 1.33
With a debt service coverage ratio (DSCR) of 1.33, operating income is 33% larger than fixed expenses. Lenders prefer borrowers with a DSCR of 1.25 or higher because it shows they can afford their debt service payments and still have some money left over.
Lenders face less risk when the DSCR is higher because it indicates that the borrower is more likely to make their loan payments. On the other hand, higher interest rates or more stringent loan terms may be applied if the DSCR is low.
A good broker will help you figure out if the property cash flows sufficiently to meet the DSCR. Want help?