Debt Coverage Ratio

Definition of Debt Coverage Ratio (DCR)

In the context of commercial mortgages, the Debt Coverage Ratio (DCR)—also frequently referred to as the Debt Service Coverage Ratio (DSCR)—is a financial metric used by lenders to measure a property's ability to produce enough income to cover its debt payments. It is expressed as a ratio that compares the property’s annual net operating income to its annual mortgage debt service.

How the Debt Coverage Ratio is Calculated

To determine the DCR, a lender divides the property’s income after operating expenses by the total amount of principal and interest payments due over a year. The formula is written as follows:

DCR = Net Operating Income (NOI) / Annual Debt Service

• Net Operating Income (NOI): This is the total income generated by the property (rent, parking fees, laundry, etc.) minus all necessary operating expenses such as property taxes, insurance, maintenance, and utilities. It does not include income taxes or the mortgage payment itself.
• Annual Debt Service: This represents the total amount of principal and interest payments required to be paid on the commercial mortgage over the course of one year.

Detailed Description and Importance

The Debt Coverage Ratio is one of the most critical factors a commercial lender evaluates during the underwriting process. It serves as a benchmark for the "cushion" a borrower has to make payments if the property's income fluctuates or expenses increase unexpectedly.

The resulting number from the calculation tells the lender the following:

• A DCR of 1.0: This is the break-even point. It indicates that the property generates exactly enough income to cover the mortgage, leaving zero profit for the owner and no margin for error.
• A DCR below 1.0: This indicates a negative cash flow. A ratio of 0.90, for example, means the property only generates enough income to cover 90% of the debt, requiring the borrower to use outside funds to make up the difference.
• A DCR above 1.0: This indicates a positive cash flow. For example, a DCR of 1.25 means the property generates 25% more income than is required to pay the mortgage.

Lender Requirements

Most commercial lenders require a minimum DCR to approve a loan, typically ranging between 1.20 and 1.35. This ensures that even if the property experiences a slight increase in vacancies or a rise in operating costs, the borrower will still have sufficient funds to remain current on the mortgage. Generally, the higher the DCR, the lower the perceived risk for the lender, which can often result in more favorable interest rates and loan terms for the borrower.

Lenders also use the DCR to determine the maximum loan amount they are willing to offer. If a property's income is not high enough to support the requested loan amount at the required DCR, the lender will likely reduce the Loan-to-Value (LTV) ratio, requiring the borrower to provide a larger down payment.