There are a few ratios lenders use to measure and control risk when granting a mortgage. A favourite is the debt service coverage ratio (DSCR), and most lenders adhere to firm rules about minimum thresholds.
The first question you may be asking is: What is DSCR and how is it calculated?
The basic equation is: net operating income (NOI) divided by total debt service.
Calculating net operating income
Most people know calculating NOI is as simple as deducting expenses from gross income. Of course, the way a lender would determine NOI is different than an owner or real estate agent would calculate it.
Owners will rarely include a vacancy factor in a fully occupied building. Lenders almost always will, even if the tenant is as reliable as a Shoppers Drug Mart or a government office.
Owners who self-manage smaller properties won’t include a management fee expense in their calculation. Why would they? Excluding it gives a truer representation of how the building performs for them.
A lender has to include that expense in calculating NOI, as a third-party property manager would be hired if we ever find ourselves in the unfortunate situation of taking a property back.
Stabilized to market standards
Some expenses are stabilized to market standards. Apartments see a wide range of figures that are considered “market” when people are estimating repairs and maintenance or wages. When marketing a property for sale, the goal is to maximize the potential NOI and eventual sale price.
This is why you commonly see expense figures that are quite low or non-existent. A lender needs to use figures that approximate reality to ensure the property can handle the debt load of a mortgage.
The “total debt service” part of the DSCR equation is much more precise and easy to determine. Anybody with a financial calculator can easily determine, down to the penny, what will be spent annually on mortgages. In an amortizing loan, this figure would include both principal and interest payment.
Some properties could have an amortizing first mortgage and an interest-only second mortgage. The total debt service would be the annual sum of both mortgages.
Now that we have both NOI and total debt, it’s as simple as dividing one into the other. If a property generated $400,000 in NOI and had total debt obligations of $300,000, you would say the DSCR is 1.33. To be clear, there is $1.33 in income to cover every dollar owing in debt payments.
Why is it important?
The amount above 1.0 DSCR is there to protect both the lender and the borrower. If a property was to experience a sharp rise in vacancy, that surplus provides a cushion against default. Most lenders want to see a minimum DSCR of 1.20 to 1.30.
If a second mortgage is added, the combined DSCR can go as low as 1.0 to 1.15. Any ratio that falls below 1.0 would need additional income injected just to meet the annual mortgage payments.
In today’s low interest rate environment, properties performing at market with strong owners are unlikely to run into loan amount restrictions due to DSCR. If they do, it’s usually in markets experiencing the most cap rate compression, as this inflates loan amounts.
The probable limiting factor for a quality loan would be other favourite lender ratios such as loan-to-value, loan-to-purchase price or loan-to-cost (construction).
The DSCR system works because it builds a buffer into the underwriting for any property. If your property is under performing in terms of NOI, it can handle less debt and the DSCR would express that. If you’re paying a higher interest rate due to a low credit score, the loan amount can be restricted to maintain the DSCR ratio.
As a borrower, it’s important to understand debt service coverage ratios. Not only does your lender care a great deal about it, but it’s a good measure of risk for your investment.
Adam Powadiuk is a business development manager with First National Financial, Canada’s largest non-bank lender. He’s active in most markets in the country, with a focus on investment real estate. All feedback is welcome and he can be reached at [email protected].