Understanding Debt Service Coverage Ratio
When you are shopping for a residential mortgage, you will find that the process is basically the same for every applicant. However, with commercial mortgages, the process can differ widely from one applicant to the next. When lenders look at commercial applications, though, there are some ratios that are used with every file.
One of these is the debt service coverage ratio, also known as DSCR. This ratio indicates whether a business or property has the ability to cover the cost of the mortgage and additional expenses connected to that property. Generally, lenders will require that the property bring in more in income than it costs in expenses — in other words, it has to have a positive cash flow. The breakeven point is a DSCR of 1.0, which means that income and expenses are equal. To get approval for a commercial loan, you need a ratio of at least 1.2, meaning that you bring in at least 20 percent more income than the expenses that you have at the property. Owner occupied businesses that do not have any income from rental generally have a higher requirement, at least 2.0, which means that the income has to be at least twice the expenses. This higher ratio requirement comes from the fact that the lender is evaluating the stability of the business rather than simply the property. The DSCR varies according to other factors as well, such as amortization, interest rate and size of the loan.
Debt Service Costs
Calculating the DSCR is an important step for a lender when determining how much he is willing to lend to a commercial borrower. The equation involves dividing the net operating income by the total debt service. Net operating income refers to the income that a rental property brings in after satisfying all of the operating expenses. When you are dealing with a rental property, lenders always require calculating for a vacancy factor, no matter what the actual occupancy is, in order to cover loss from collections. Lenders also require a management factor that costs between 3 and 6 percent of the effective gross income, even in cases where the owner manages the property, because the lender would have to pay for the costs of management if they had to take back the property. The total debt service refers to the interest and principal payments required for all loans on this property, rather than the first mortgage only. Taxes and insurance were already part of the operating expenses above.
Debt Service Ratios
Obviously, the greater your DSCR, the more net operating income you have in place to take care of the debt. From the point of view of a lender, the higher the ratio, the better. The majority of borrowers want as much in their loan as they can get. A larger loan means higher mortgage payments — and more debt service. If net operating income remains unchanged, but the size of the loan and as a result the debt service go up, meaning that the DSCR goes down. Mortgage banks are often willing to go as low as a DSCR of 1.10, while 1.20 is a fairly standard DSCR for this type of lender. Life insurance companies often have a more conservative DSCR requirement, often between 1.25 and 1.35.
Another important term in the commercial lending industry is LTV, or Loan-to-Value. This calculates the property percentage that is undergoing financing. Many residential programs will go as high as 95%. However, the majority of commercial lending programs do not go above 60 or 75 percent, varying with the type of property, location, and other variables.
Some borrowers mistake the difference between total debt service and DSCR. The total debt service is the denominator in the calculation that yields DSCR.
If you are looking for a commercial mortgage for your property or business, and you do not qualify for traditional commercial financing; Amansad Financial has the alternative lending sources that will to provide private financing. The different types of lenders are out there to fulfill different needs, related to borrower circumstances. No matter what sort of property you want to seek a mortgage for, Amansad Financial can assist in your situation. Contact us to find the best loan for your situation.
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