A DSCR loan, also known as a debt service coverage ratio loan, is a type of commercial real estate loan that uses a property’s net operating income to determine the maximum loan amount. The debt service coverage ratio (DSCR) compares a property’s net operating income to its total debt obligations. Lenders use this ratio to assess the risk of a loan and the borrower’s ability to repay it.
What is DSCR?
DSCR stands for debt service coverage ratio. It is a financial metric used by commercial real estate lenders to determine the feasibility of a loan.
The debt service coverage ratio compares a property’s net operating income to its total debt obligations over a 12-month period. Net operating income is a property’s gross income minus its operating expenses. Debt obligations include the mortgage principal, interest, taxes and insurance payments (PITI).
The DSCR formula is:
DSCR = Net Operating Income / Total Debt Obligations
A DSCR of 1.0 means the property’s net operating income equals its total debt obligations. A DSCR higher than 1.0 is favorable because it shows there is surplus income after paying all debt obligations.
Lenders have minimum DSCR requirements, often between 1.20 to 1.25 for commercial properties. The higher the DSCR, the lower the risk of default.
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How DSCR Loans Work
With a DSCR loan, the maximum loan amount is determined by the property’s net operating income and the lender’s minimum DSCR requirement.
For example:
- A property has $100,000 in net operating income
- The lender requires a minimum 1.25 DSCR
- To meet a 1.25 DSCR, the maximum annual debt obligation is:
$100,000 / 1.25 = $80,000
So for this property, the lender would approve a maximum loan amount that has total annual debt obligations of $80,000. This ensures the property can meet the minimum 1.25 DSCR requirement.
The loan amount may be lower or higher depending on factors like the loan term, interest rate, amortization schedule, and loan-to-value ratio. The bottom line is the loan cannot exceed an amount with $80,000 total annual debt obligations.
Benefits of DSCR Loans
DSCR loans offer several benefits for commercial real estate investors:
Lower Down Payment – Lenders focus on the property’s income rather than the borrower’s credit or income. This allows investors to get loans with a minimum 10-20% down payment.
No Personal Guarantee – DSCR loans do not require a personal guarantee from the borrower. The loan is based solely on the underlying property’s ability to repay it.
Flexible Terms – DSCR loans offer more flexible terms than conventional loans, including higher leverage, longer amortization, and interest-only options.
Cash-Out Refinancing – Borrowers can take cash out with a DSCR refinance up to 75% loan-to-value. This unlocks property equity for other investments.
Non-Recourse – DSCR loans are typically non-recourse, meaning the lender cannot go after your other assets if the property defaults. Their only recourse is taking back the secured property.
Predictable Payments – DSCR loans often have fixed-rate interest and principal payments that are predictable for budgeting.
No Prepayment Penalties – Most DSCR loans allow paying off the balance early with no prepayment penalties.
DSCR Loan Requirements
While DSCR loans offer more flexible qualifying criteria than conventional mortgages, there are still requirements borrowers must meet:
- Minimum DSCR – The property must generate sufficient net operating income to meet the lender’s minimum DSCR, usually around 1.20 to 1.25.
- Loan-to-Value – The maximum LTV ratio allowed is typically 70-75% for a DSCR purchase loan or refinance.
- Property Type – Lenders generally limit DSCR loans to multi-family, retail, office, industrial, hospitality, healthcare, and mixed-use commercial properties. Special purpose properties are usually ineligible.
- Minimum Loan Size – Many lenders require minimum loan amounts between $500,000 to $1,000,000+.
- Debt Yield Ratio – This metric compares the property’s net operating income to the loan balance. Minimum debt yields are usually around 10-12%.
- Borrower Experience – Having experience owning and operating commercial real estate improves DSCR loan eligibility.
- Personal Liquidity – Lenders often want borrowers to have 12-24+ months of liquidity to cover any cash flow shortfalls.
- Reserves – There may be requirements for 6-12 months of reserve funds for major capital expenditures or vacancies.
- Location – The property should be in a qualified location based on factors like market fundamentals, economic health, and supply/demand dynamics.
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How to Calculate DSCR
Follow these steps to calculate a property’s debt service coverage ratio when applying for a DSCR loan:
- Determine Gross Potential Income – Add up all revenue the property can generate if 100% occupied at current rental rates. Include base rent, CAM reimbursements, parking fees, storage rentals, pet fees, laundry facilities, and any other recurring income.
- Calculate Vacancy Factor – Estimate likely economic vacancy based on the property’s historical vacancy rate and current market conditions. Apply this as a percentage deduction to the gross potential income.
- Add Other Income – Account for any predictable non-rental income like billboard/cell tower revenue, vendor commissions, late fees, forfeited deposits, etc.
- Total Effective Gross Income – The gross potential income minus the vacancy factor plus other income totals the property’s effective gross income.
- Deduct Operating Expenses – Subtract all operating expenses to arrive at the net operating income. Examples include property taxes, insurance, repairs and maintenance, management fees, utilities, landscaping, trash removal, pest control, advertising, professional services, supplies, etc. Do not include capital expenditures or mortgage payments.
- Determine Total Debt Obligations – Calculate the annual total of principal, interest, taxes and insurance payments (PITI) at the loan amount and terms you are requesting.
- Divide NOI by Total Debt – Finally, divide the net operating income by the total annual debt obligations to get the DSCR.
It helps to organize this calculation in a spreadsheet to easily update the variables when modeling different scenarios. Work closely with your commercial real estate broker to determine accurate projections.
How to Find DSCR Loans
The niche nature of DSCR loans means not every lender offers them. Here are some options to consider when looking for DSCR financing:
- Mortgage Brokers – An experienced commercial mortgage broker is a good starting point. They have relationships with multiple DSCR lenders and can help find competitive loan terms.
- Portfolio Lenders – Many non-bank and alternative lenders offer DSCR loans. They lend from their own funds rather than selling loans to the secondary market. This provides them with more flexibility.
- Banks and Credit Unions – Some local and regional banks and credit unions offer DSCR loans, but usually with more conservative terms than alternative lenders.
- Life Insurance Companies – Institutional lenders, like life insurance companies, are active in commercial real estate lending. They have large reserves of capital from policyholder premiums to fund mortgages.
- Pension Funds – Public and private pension funds look to earn steady returns through commercial real estate debt. They may directly originate or purchase DSCR loans.
- REITs – Real estate investment trusts focused on mortgages and commercial lending sometimes finance DSCR loans.
- Crowdfunding – New fintech platforms are aggregating capital from individual and institutional investors to finance real estate projects via crowdfunding.
- Hard Money Lenders – Also known as bridge lenders, hard money loans are an option for borrowers who need funds quickly but may not meet all DSCR criteria. Rates are typically much higher.
Work with an experienced advisor to shop multiple lenders and negotiate the most favorable DSCR loan terms.
Pros and Cons of DSCR Loans
DSCR loans offer many advantages but also come with drawbacks to consider:
Pros
- Higher leverage and lower equity requirements
- Flexible qualifying guidelines
- Low down payments with no PG
- Interest-only payments to preserve capital
- Non-recourse terms limit personal liability
- Fixed-rate loans have predictable payments
- No prepayment penalties for early payoff
Cons
- Require higher minimum DSCR than conventional loans
- Limited mostly to multi-family, retail, office, industrial properties
- Often have slightly higher interest rates
- Limited recourse if property underperforms
- Require commercial real estate experience
- Have strict requirements for reserves, location, LTV
Evaluate both the pros and cons relative to your business objectives, timeline, experience level, and risk tolerance when deciding if a DSCR loan is the right fit.
Tips for Getting DSCR Loan Approval
Follow these tips to improve your chances of successfully obtaining DSCR financing:
- Shop multiple lenders – Get loan quotes from several portfolio and alternative lenders to find the best rate and terms. Avoid applying multiple times as too many inquiries can impact approval odds.
- Optimize your DSCR – If your property’s DSCR is borderline, look for ways to minimize operating expenses or boost income to improve it. Even small optimizations can get you qualified.
- Highlight experience – Emphasize your background owning, operating and managing commercial real estate assets if applicable. This reassures lenders despite less focus on personal income and credit.
- Have capital reserves – Lenders want to see you have adequate reserves or access to capital to carry the property through unexpected cash flow interruptions.
- Get your documents in order – Have all required financial records, tax returns, profit and loss statements, and property details ready for loan underwriting. Incomplete information causes delays.
- Consider loan enhancements – Options like setting up a debt service reserve, paying points to buy down the rate, or taking a shorter term can improve DSCR loans odds.
- Bring equity to close – Being prepared to inject more cash equity if needed shows you’re committed to the property’s success. Skin in the game matters.
Securing commercial real estate loans with a low down payment can accelerate your ability to scale. DSCR loans allow doing so while keeping personal liability low. But they require rigorous financial diligence. Put in the work upfront with your broker and lender to get your DSCR loan application approved.
The Bottom Line
DSCR loans let investors purchase and refinance commercial real estate with less money down by focusing on the property’s income rather than personal factors. A higher ratio gives more financing flexibility. Pay close attention to the lender’s minimum requirement and understand how to optimize your DSCR. With the right property and some experience, a DSCR loan can be your ticket to growing a larger commercial real estate portfolio.
FAQs About DSCR Loans
Below are answers to some frequently asked questions about DSCR loans:
What is the minimum DSCR requirement?
Most lenders have a minimum DSCR requirement between 1.20 and 1.25. So for a 1.25 DSCR, the property’s net operating income must be at least 125% of its annual debt obligations. The higher the DSCR, the more comfortable lenders feel about the loan being repaid.
What is a good DSCR?
A good or acceptable DSCR depends on the lender’s requirements as well as the property type, location, age, and other factors. In general, a DSCR above 1.4 is considered excellent, while a DSCR below 1.15 may get increased scrutiny from lenders.
How is DSCR calculated for an existing property?
To calculate DSCR for an existing property, use its trailing 12 months of financial statements to determine the net operating income. Get a mortgage quote at the loan amount needed and calculate new PITI. Divide NOI by the total new PITI to get the DSCR.
Can I get a DSCR loan for an investment property?
Yes, DSCR loans are commonly used by real estate investors to purchase or refinance investment properties like apartment buildings, retail centers, self storage, and so on. Lenders mainly focus on the property’s DSCR, not personal income or credit.
What is better, a higher or lower DSCR?
A higher DSCR is better from both the lender and borrower’s perspective. A higher ratio indicates the property has greater ability to comfortably repay debts. And it allows the borrower to potentially qualify for more financing.
Do DSCR loans require a down payment?
Most lenders require a minimum 10-20% equity contribution or down payment on a DSCR loan. Higher down payments allow more leverage. For example, 20% down enables financing at an 80% LTV. Some lenders may accept 5-10% equity for the right situation.
Can I get a DSCR loan for an owner-occupied commercial property?
While less common, it is possible to get DSCR financing for an owner-occupied commercial property. The loan would need to conform to typical DSCR requirements regarding property type, location, minimum DSCR, LTV limits, reserves, etc.
Are DSCR loans assumable?
DSCR loans are very rarely assumable to another borrower. The new buyer would need to apply and qualify for their own DSCR loan based on the property’s updated financials and their experience operating commercial real estate.
What happens if the DSCR drops too low during the loan?
DSCR covenants give the lender options if the ratio drops too far below the minimum requirement. For example, they may force the borrower to repay a portion of principal or place funds in a reserve account. It could trigger technical loan default.
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