One of the most essential tools to evaluate the financial health of an income-producing property is the Debt Service Coverage Ratio (DSCR). Whether you’re financing a rental property, analyzing a commercial asset, or preparing for a refinance, DSCR helps determine whether a commercial property’s income can comfortably cover its debt obligations. Below, learn about how to calculate the debt service coverage ratio and its importance.
How is the DSCR Used?
DSCR is a key financial indicator used to evaluate whether a property generates enough income to cover its debt obligations, which include both principal and interest payments on a mortgage. For commercial real estate investors, the DSCR helps determine if an investment is financially viable and sustainable over time. Lenders use the DSCR in risk assessment, as it indicates if a borrower is likely to be able to repay their loans. A higher DSCR score usually means a property has a more stable income stream and a lower risk of missed payments, making the investment more attractive to both banks and buyers.
How to Calculate the DSCR
DSCR = Net Operating Income (NOI) / Annual Debt Service
- Net Operating Income (NOI) is the total income from the property minus operating expenses (including property management, insurance, taxes, maintenance, and utilities).
- Annual Debt Service includes all current debt obligations for the year.
What Determines a Good DSCR?
DSCR is more than just a number—it’s a key factor in whether you can secure financing. Lenders assess it to gauge risk: a higher DSCR means more income relative to debt obligations, making the investment appear safer and more stable.
- DSCR > 1.20: Indicates a strong income cushion; the property generates 20% more income than it needs to pay the mortgage.
- DSCR = 1.00: Indicates the property will break even; earning just enough income to pay the mortgage.
- DSCR < 1.00: Indicates danger; the property does not produce enough income to cover debt service, increasing the likelihood of default.
Most commercial lenders require a minimum DSCR of 1.20–1.25, although some may accept lower ratios for stabilized, low-risk, or new properties. A lower DSCR might still be financeable, but lending agreements are likely to include higher interest rates or more stringent terms.
Example of DSCR Calculation
Let’s analyze a medical office building. The property generates $600,000 in Net Operating Income (NOI) annually, and its annual debt payments (principal + interest) come out to $450,000. To calculate the DSCR:
DSCR = 600,000 / 450,000 = 1.33
The property generates 33% more income than needed to cover its debt. This is generally considered a good DSCR because it offers a financial cushion that protects against vacancies, maintenance surprises, or market dips.
Factors Impacting DSCR Calculation
A property’s DSCR calculation can be influenced by a variety of factors, including:
- Net operating income (NOI): any increase in rent or decrease in operating expenses will improve DSCR. Efficient property management, minimizing vacancies, and controlling costs like insurance or maintenance can all boost NOI.
- Debt service (loan payments): higher interest rates, shorter loan terms, or large balloon payments can drag your DSCR down quickly. Even small changes in financing structure—like switching from a 30-year to a 20-year amortization—can have a noticeable effect.
- Market conditions: a downturn might pressure rents or increase vacancy, cutting into NOI and pushing DSCR lower. Both property performance and loan structure must align to maintain a strong, sustainable DSCR.
Advantages and Disadvantages of the DSCR
While the DSCR is a good shorthand for a property’s overall financial health, it has both benefits and drawbacks.
Advantages: DSCR is simple and widely used by lenders, making it a standard part of commercial loan and investment agreements. It helps investors gauge at a glance whether a property can cover debt, especially when tracked over time. Maintaining a strong DSCR can help properties achieve better loans and lower interest rates as it increases investor confidence.
Disadvantages: However, calculating the DSCR alone doesn’t tell the full financial story. It doesn’t account for one-time expenses, capital improvements, or future rent fluctuations. It also assumes the property has a steady income, which isn’t always true for seasonal markets or during vacancies. Additionally, aggressive accounting can inflate NOI, giving a distorted view of performance.
While DSCR is essential for due diligence and loan approval, it should always be analyzed alongside other metrics like cap rate, LTV, and cash-on-cash return.
Why is Calculating DSCR Important for Investors?
The Debt Service Coverage Ratio helps commercial investors and lenders decide whether a property’s income will be able to cover its debt payments. It’s not just a measure of risk—it’s a tool for making smarter investment decisions. A strong DSCR demonstrates that a property generates enough income to support financing, while a weak one can catch issues early, before they become serious problems. By focusing on income versus debt obligations, DSCR is uniquely useful for investors evaluating the sustainability of a deal and lenders looking to structure responsible loans.
Use STRATAFOLIO to Calculate DSCR
Commercial real estate software STRATAFOLIO can simplify your process and help you make informed decisions by calculating DSCR for your properties. Schedule a demo today!
