Commercial mortgage DSCR, explained

The debt service coverage ratio (DSCR) is one of the two numbers that decide how much a commercial lender will lend. The other is loan-to-value (LTV). Understanding both helps you see a commercial mortgage the way a lender does.

The formula

DSCR compares a property's income with its mortgage payments:

DSCR = Net operating income ÷ Annual debt service

• Net operating income (NOI) is the property's income after vacancy and operating expenses, but before mortgage payments and income tax.
• Annual debt service is the total of the mortgage payments, principal and interest, over twelve months.

A worked example

This example is illustrative only.

A small mixed-use building earns $248,000 a year in rent. After allowing for vacancy and paying property taxes, insurance, utilities, repairs and management, its NOI is $186,000.

The proposed mortgage payments total $148,800 a year.

$186,000 ÷ $148,800 = 1.25x

The property earns 1.25 times what it needs to cover the mortgage payments.

What the result means

• Below 1.00x: the property's income doesn't cover its mortgage payments.
• At 1.00x: income exactly covers the payments, with no margin for vacancy or unexpected costs.
• Above 1.00x: there is a cushion. Lenders require a minimum above 1.00x, and the minimum depends on the lender, the property type and the loan program.

Why the lender's number may differ from yours

Lenders recalculate NOI with their own assumptions instead of taking the owner's figures as given. They may:

• apply a standard vacancy allowance even if the building is fully leased,
• include a management fee even if you manage the property yourself,
• add a reserve for future repairs and replacements,
• use market rents or the in-place rents, whichever is more conservative.

Lenders may also calculate debt service using a qualifying rate higher than the actual contract rate. Each of these adjustments lowers DSCR.

DSCR and LTV work together

A lender typically sizes the loan to whichever measure is more restrictive. A property might support 75% LTV on its appraised value, but if its income only supports a smaller loan at the lender's minimum DSCR, the loan will be the smaller amount. That's why the income side of a commercial property often matters as much as its value.

How to strengthen a commercial application

1. Prepare clean operating statements for the last two or three years.
2. Provide a current rent roll and copies of major leases.
3. Explain any one-time costs or unusual vacancy.
4. Have your own financial statements and net worth summary ready.

You can test your own numbers with the DSCR calculator on the commercial mortgages page.

This article is general information about commercial mortgage financing in Ontario. It is not investment, tax, legal or financial advice, and any example is illustrative only.