Understanding Debt Service Coverage Ratios

The debt service coverage ratio (DSCR) measures an ability of a property to meet its debt obligations. It’s expressed as the ratio between an asset’s net operating income (NOI) and its debt service costs.

Net operating income includes all income earned by a property, minus operating expenses (including taxes, management fees, etc.). Debt services costs include both the principal and interest payments on any outstanding loans.

For example, a debt service coverage ratio of 1.0 means that an asset has exactly enough operating income to cover its operating expenses. Another way to conceptualize this is that the property generates $1 in income for every $1 in payments owed to the lender. 

Lenders use the debt service coverage ratio as a gauge of a property’s financial condition and creditworthiness. From a lender’s perspective, the higher the DSCR, the better. Some lenders will include the DSCR and other measures of solvency as covenants (conditions to be met) in their loan agreements. One example is the cash flow sweep. Under this condition, if an asset doesn’t have the net operating income to maintain a specific DSCR covenant, the lender is entitled to put any free cash flow into a reserve account to pay down the balance of the loan.

Investors should consider examining debt service coverage ratio as a part of their diligence on a property before investing. If a property’s NOI is substantially higher than its DSCR covenant, there is generally a lower risk of defaulting on a loan. Generally, lenders expect a property to generate 1.25x - 1.50x+ more income than debt service; a property generating substantially more than that may be a safer investment. However, an asset with a low DSCR may present a savvy operator with opportunities to reduce costs or raise rents, which would increase net operating income and thus improve the DSCR over the long term. 

It’s important to note that the debt service coverage ratio represents a fixed period of time, often the preceding twelve months. This can lead to distortions: for example, during the height of the COVID-19 pandemic, when many office and retail building operators faced shortfalls in rental income. In such a situation, where NOI falls but operating costs remain fixed, DSCRs can drop below 1.0. If the situation continues over an extended period of time (e.g. during a prolonged economic downturn), the property owners may be forced to default on their loan obligations.

LEX Markets does not provide tax, legal or accounting advice. Potential investors are encouraged to consult with professional tax, legal, and financial advisors before making any investment into a securities offering. This investment may not be suitable for all investors. Distributions and liquidity not guaranteed. Property performance and performance of property tenants not guaranteed. Diversification does not eliminate the risk of experiencing investment loss.

November 15, 2022

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