Debt service coverage ratio

The debt service coverage ratio (DSCR), is the ratio of cash available for debt servicing to interest, principal and lease payments. It is a popular benchmark used in the measurement of an entity's (person or corporation) ability to produce enough cash to cover its debt (including lease) payments. The higher this ratio is, the easier it is to obtain a loan. The phrase is also used in commercial banking and may be expressed as a minimum ratio that is acceptable to a lender; it may be a loan condition or covenant. Breaching a DSCR covenant can, in some circumstances, be an act of default.

Uses

In corporate finance, DSCR refers to the amount of cash flow available to meet annual interest and principal payments on debt, including sinking fund payments.

In personal finance, DSCR refers to a ratio used by bank loan officers in determining debt servicing ability.

In commercial real estate finance, DSCR is the primary measure to determine if a property will be able to sustain its debt based on cash flow. In the late 1990s and early 2000s banks typically required a DSCR of at least 1.2, but more aggressive banks would accept lower ratios, a risky practice that contributed to the Financial crisis of 2007–2009. A DSCR over 1 means that (in theory, as calculated to bank standards and assumptions) the entity generates sufficient cash flow to pay its debt obligations. A DSCR below 1.0 indicates that there is not enough cash flow to cover loan payments.

Calculation

In general, it is calculated by: DSCR = Annual Net Income + Amortization/Depreciation + other non-cash and discretionary items (such as non-contractual management bonuses) / Principal Repayment + Interest payments + Lease payments

To calculate an entity’s debt coverage ratio, you first need to determine the entity’s net operating income. To do this you must take the entity’s total income and deduct any vacancy amounts and all operating expenses. Then take the net operating income and divide it by the property’s annual debt service, which is the total amount of all interest and principal paid on all of the property’s loans throughout the year. If a property has a debt coverage ratio of less than one, the income that property generates is not enough to cover the mortgage payments and the property’s operating expenses. A property with a debt coverage ratio of .8 only generates enough income to pay for 80 percent of the yearly debt payments. However, if a property has a debt coverage ratio of more than 1, the property does generate enough revenue to cover annual debt payments. For example, a property with a debt coverage ratio of 1.5 generates enough income to pay all of the annual debt expenses, all of the operating expenses and actually generates fifty percent more income than is required to pay these bills.

A DSCR of less than 1 would mean a negative cash flow. A DSCR of less than 1, say .95, would mean that there is only enough net operating income to cover 95% of annual debt payments. For example, in the context of personal finance, this would mean that the borrower would have to delve into his or her personal funds every month to keep the project afloat. Generally, lenders frown on a negative cash flow, but some allow it if the borrower has strong outside income.

Typically, most commercial banks require the ratio of 1.15 - 1.35 times (net operating income or NOI / annual debt service) to ensure cash flow sufficient to cover loan payments is available on an ongoing basis.

Example

Let’s say Mr. Jones is looking at an investment property with a net operating income of $36,000 and an annual debt service of $30,000. The debt coverage ratio for this property would be 1.2 and Mr. Jones would know the property generates 20 percent more than is required to pay the annual mortgage payment.

The Debt Service Ratio is also typically used to evaluate the quality of a portfolio of mortgages. For example, on June 19, 2008, a popular US rating agency, Standard & Poors, reported that it lowered its credit rating on several classes of pooled commercial mortgage pass-through certificates originally issued by Bank of America. The rating agency stated in a press release that it had lowered the credit ratings of four certificates in the Bank of America Commercial Mortgage Inc. 2005-1 series, stating that the downgrades "reflect the credit deterioration of the pool". They further go on to state that this downgrade resulted from the fact that eight specific loans in the pool have a debt service coverage (DSC) below 1.0x, or below one times.

The Debt Service Ratio, or debt service coverage, provides a useful indicator of financial strength. Standard & Poors reported that the total pool consisted, as of June 10 2008, of 135 loans, with an aggregate trust balance of $2.052 billion. They indicate that there were, as of that date, eight loans with a DSC of lower than 1.0x. This means that the net funds coming in from rental of the commercial properties are not covering the mortgage costs. Now, since no one would make a loan like this initially, a financial analyst or informed investor will seek information on what the rate of deterioration of the DSC has been. You want to know not just what the DSC is at a particular point in time, but also how much it has changed from when the loan was last evaluated. The S&P press release tells us this. It indicates that of the eight loans which are "underwater", they have an average balance of $10.1 million, and an average decline in DSC of 38% since the loans were issued.

And there is still more. Since there are a total of 135 loans in the pool, and only eight of them are underwater, with a DSC of less than 1, the obvious question is: what is the total DSC of the entire pool of 135 loans? The Standard and Poors press release provides this number, indicating that the weighted average DSC for the entire pool is 1.76x, or 1.76 times. Again, this is just a snapshot now. The key question that DSC can help you answer, is this better or worse, from when all the loans in the pool were first made? The S&P press release provides this also, explaining that the original weighted average DSC for the entire pool of 135 loans was 1.66x, or 1.66 times.

In this way, the DSC (debt service coverage) ratio provides a way to assess the financial quality, and the associated risk level, of this pool of loans, and shows the surprising result that despite some loans experiencing DSC below 1, the overall DSC of the entire pool has improved, from 1.66 times to 1.76 times. This is pretty much what a good loan portfolio should look like, with DSC improving over time, as the loans are paid down, and a small percentage, in this case 4%, experiencing DSC ratios below one times, suggesting that for these loans, there may be trouble ahead.

And of course, just because the DSC is less than 1 for some loans, this does not necessarily mean they will default. As of the date of the S&P press release, the trust which holds the 135 loans has not experienced any losses.

References

Abhay