In recent 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 the net operating income, or NOI, for a building. This is key, because it tells us how much, after expenses, the building earns. And remember, in a commercial loan the key is what the building earns. This is why buildings next to each other with the same number of stores and apartments above them 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 to earn on his or her investment. We show how this number, along with the NOI, can give us an idea of what a building is worth.
Debt Service Coverage Ratio or DSCR
Now we are going to look at the most important number, the number that will go a long way in determining whether or not a commercial mortgage loan can be financed. It’s a number that can reduce your loan amount, or potentially even increase it. This number is the debt service coverage ratio, or DSCR. Remember what we said earlier in Article 1. Commercial mortgage loans are not about LTV, they are about DSCR.
DSCR is not a complicated formula, but it will tell us whether the debt service (principal + interest) on a given loan amount at a given interest rate will be adequately covered by the NOI the building produces. Again? Will the annual NOI divided by the desired loan’s annual debt service coverage result in a high enough DSCR to satisfy the lender? Typically the minimum DSCR level will be 1.20X or 1.25X depending on the type of property.
Remember that the mortgage rate cannot be higher than the capitalization rate, or the building will not pay the debt. Another way of looking at it: You can’t borrow money at Bank 1 at 7% and invest it at Bank 2 at 6%. This is not a winning proposition, and in terms of commercial mortgages, you won’t get the DSCR you need.
Now let’s take a look at an example. Remember that the calculations are not complicated, but the results are critical to the success or failure of the loan financing:
NOI = $80,000 Annual Mortgage Expense = $65,000
DSCR = $80,000/$65,000 = 1.23X, which is fine for certain types of properties
What if the NOI goes down or mortgage expenses go up?
NOI = $75,000 Annual Mortgage Expense = $68,000
$75,000/$68,000 = 1.1X DSCR which is not a good number.
One way around this is a lower loan amount which will result in a lower mortgage expense. This will require a higher down payment for a purchase or lower income for a refinance.
In any case, the conclusion remains that:
Income producing property must be able to support itself!