Commercial lenders also study the Debt-Service Coverage Ratio (DSCR), which compares the real estate’s annual net operating income (NOI) with its annual mortgage debt service (including principal and interest) to measure the real estate’s ability to repay debt. It is calculated by dividing the NOI by the annual debt service.
For example, a property with a NOI of $130,000 and an annual mortgage debt service of $100,000 has a DSCR of 1.3 ($130,000 ÷ $100,000 = 1.3). This ratio helps lenders determine the maximum loan amount based on the cash flow generated by the property.
DSCR less than 1 indicates negative cash flow. For example, a DSCR of 0.92 means that only the NOI is sufficient to cover 92% of the annual debt service. In general, commercial lenders expect a DSCR of at least 1.25 to ensure adequate cash flow.
For properties with a short amortization period and/or stable cash flow, a lower DSCR is acceptable. For real estate with volatile cash flows (for example, hotels), a higher ratio may be needed, and hotels lack long-term (and therefore more predictable) tenant leases common to other types of commercial real estate.