Analyzing a Commercial Mortgage Loan – Debt Service Coverage Ratio
In the past few articles, some of the criteria and analysis that go into determining the viability of a commercial mortgage loan have been discussed. We’ve looked at how we arrive at a building’s net operating income, or NOI. This is key, because it tells us how much the building earns after expenses. And remember, the key in a commercial loan is what the building earns. This is why adjacent buildings with the same number of shops and apartments above can be worth two different amounts. Different levels of NOI! We’ve looked at the capitalization rate, or the return a commercial property buyer wants on their investment. We showed how this number, together with the NOI, can give us an idea of a building’s value.
DSCR debt service coverage ratio
We will now look at the most important number, one that will go a long way in determining whether or not a commercial mortgage loan can be financed. It is a number that can lower the loan amount, or maybe even increase it. This number is the debt service coverage ratio, or DSCR. Remember what we said early on in Article 1. Commercial mortgages are not about mortgages, but they are about DSCR.
DSCR is not a complicated equation, but it will tell us whether the debt service (principal + interest) for a given loan amount at a given interest rate will be adequately covered by the NOI produced by the building. once again? Will the annual NOI divided by the annual debt service coverage of the desired loan cause the DSCR to be high enough to satisfy the lender. Usually, the minimum DSCR level will be 1.20X or 1.25X depending on the type of characteristic.
Remember that the mortgage rate cannot be higher than the cap rate, or the building will not service the debt. Another way to look at it: You can’t borrow money in Bank 1 at 7% and turn around and invest it in Bank 2 at 6%. This is not a winning proposition, and in commercial mortgage terms you will not get the DSCR you need.
Now let’s look at an example. Remember, the calculations aren’t complicated, but the results are crucial to the success or failure of your loan financing:
NOI = $80,000 Annual Mortgage Expenses = $65,000
DSCR = $80,000 / $65,000 = 1.23X which is appropriate for certain types of property
What if NOI goes down, or mortgage expenses go up?
NOI = $75,000 Annual Mortgage Expenses = $68,000
$75,000 / $68,000 = 1.1X DSCR which is not a good number.
A way around this is to lower the loan amount which will result in lower mortgage expenses. This will require a larger down payment for the purchase, or lower returns if refinancing.
Anyway, the bottom line is still:
Income generating property must be able to support itself!