Number 2: Debt Service Coverage Ratio (DSCR)
Debt Service Coverage Ratio is a ratio to measure by how much the net operating income (NOI) covers the current debt service. As we learned in the previous post about the key metric Debt Yield, the debt service describes the sum of the interest and the amortization in any given period. So if my interest rate is 2.0% p.a. and my debt is amortized by 3.0% p.a., my debt service is thus 5.0%.
To calculate the debt service coverage ratio, we divide the net operating income by the total debt service.
As you can see, we need the concept of net operating income not only for calculating the Debt Yield but also the DSCR.
We use the same example as in the previous case, in which we assumed that our real estate generates a net operating income of € 5,000 in year 0 with an NOI growth of 2.0% each year. The forecasting period in our case is again 5 years.
Further, we assume that the property is financed with a loan of € 100,000. The interest rate is set to 1.5% p.a. with a linear amortization of 2.0% p.a. This results in an initial debt service of 3.5% (1.5% interest + 2.0% amortization). After reducing the NOI by the interest and amortization we get a cash flow after debt service.
The concept of the debt service coverage ratio assumes that we use our NOI to cover for our debt service expenses. In fact what we like to see is a NOI that is greater than the expenses for interest and amortization. If this is the case, we have a DSCR that is greater than 1x. In year 1 we have a DSCR of 1.43x. This is calculated by dividing the NOI of € 5,000 by the debt service of year 1 which is € 3,500.
What does that mean now? Well in fact our cash flow is large enough to cover for your financing expenses. We are currently in a surplus and can “afford” to pay the interest and amortization. A worse situation would be once our NOI would not cover the total debt service. This indicates that either the cash flow is too low, the interest or amortization costs are too high, or both. The result is a cash flow shortfall that has to be covered for example by additional equity or cash coming from somewhere outside the transaction.
What you should look for in a debt service coverage ratio
- A higher debt service coverage ratio indicates less risk and a less aggressive / more suitable financing.
- An increasing debt service coverage ratio is better than a decreasing debt service coverage ratio.
- Be proactive when you notice that your debt service coverage ratio might not be sufficient. Think of a savings period to cover either for some underfunding, or as a cash cushion to put banks in a good mood.
On a side note…
Debt service coverage ratios can be stated quite differently. First, not everyone says “debt service coverage ratio” (DSCR). Some just say “debt service cover” (DSC). If you encounter a financing without an amortization, a so-called bullet financing, the debt service coverage ratio just becomes an interest coverage ratio. In this case the debt service only includes an interest portion.
DSCR can be written as a multiple such as 1.43x, as I did in the example above. However, one can also write the DSCR as a percentage. In our case it would be 143% for the first year.
There is a ton of material out there. I once again can recommend the page about the Debt Service Coverage Ratio from PropertyMetrics.
This was number 2 of the most important KPIs for banks. Check out the number 1 KPI that banks look for.
Can you guess which one it is?