Commercial Debt Service Ratio - Debt Service Coverage Ratio (DSCR)
Commercial real estate investing continues to be a wildly popular form of investing. Real estate is also one of the most versatile investments a potential investor can make. One of the potentially lucrative fields of real estate investing is rental property. Banks and other lending institutions have come up with quite an ingenious manner in which to protect their interests when deciding the risks involved in lending money on certain properties. This method is a formula that is known as the Commercial Debt Service Coverage Ratio, or DSCR.
The formula for DSCR really comes down to basic accounting. The commercial debt service coverage ratio formula is the net operating income divided by the cost of the mortgage debt. To determine the net operating income you will take the total potential income and subtract an acceptable amount of loss (such as vacancies and collections). This will determine your gross income.
Debt Service Coverage Ratio / Mortgage Debt Service = Net Operating Income
Once you've determined your gross income you will need to subtract your general operating expenses. These are things such as utilities, property maintenance, and/or inventory. Some of these are fixed amounts and some are variable. You will want to use your best guess for this because it is not in your best interest to under evaluate the variable costs or to over evaluate them. Subtract your operating expense from your gross income to determine your net operating income.
Effective Gross Income â€“ Total Operating Expenses = Net Operating Expenses
Once you've determined your net operating income for the year, you add your yearly mortgage expenses and divide your income by your expenses. There you have the debt service coverage ratio for your property. Now here's the fun part. If that number isn't greater than one your chances of getting a loan are virtually non-existent.
Net Operating Income / Mortgage Debt Service = $650,000 / $500,000 = 1.3
The bank wants the DSCR to be as large as possible as the greater this number, the smaller their risk. Banks aren't generally in the business of charity although there are exceptions to every rule so it isn't completely impossible to be approved if the DSCR is lower than one, but very improbable. This is probably a good thing however because you want your investment property to turn a profit. In other words, you want the number to be more than one just as much, if not more than the bank or lending institution does.
The most important thing to keep in mind when choosing your investment property and applying for the financing you need is that both you and the lending institution that you choose want you to succeed. Your success makes money for both you and your lender. If you are declined on a property because of the Commercial Debt Service Coverage Ratio, it doesn't mean you have to give up on your dream of owning an investment property it means that you might want to choose a property that will require less maintenance and upkeep or that is located in a different part of town where vacancies are less common. This is a business venture for you and the bank, don't take setbacks personally.
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