January 5, 2021
There’s no all-encompassing metric that provides the perfect snapshot of a CRE property, but the debt coverage ratio (DCR) is one that many lenders and investors use
What Is the Debt Coverage Ratio?
The debt coverage ratio, also called the debt service coverage ratio, is a metric that shows the financial position of a company in relation to their debt. When you do the calculations, you end up with a number that represents how many times the debt could be paid in a year with the income levels in that year.
DCR isn’t a measure that makes too much sense for personal finance, though it is sometimes used for larger personal loans. However, it’s a good measure to help a lender understand if a company can reasonably afford new debt and for a potential investor to determine if a property is worth the cost.
There are two ways of calculating the DCR. The simplest method is to divide the NOI of a property by its annual debt obligation.
If you need the formula, it looks like this
Debt Coverage Ratio = Net Operating Income (NOI) / Annual Debt Obligations
Net operating income is your earnings after expenses, excluding tax and interest payments. Debt obligation includes annual payments to both the principal and interest on existing loans and potential new loans that will be taken out to purchase the property.
The second way of calculating the DCR is to subtract capital expenditures from your NOI and continue the calculations the same as before. This second method helps to remove capital injections from the equation so that the business is judged on its own without considering extra investments.
How DCR Is Used
Both investors and lenders regularly use DCR as a metric for judging a property. It’s a measure that gives a broad picture of the current financial position of a property, as well as how well it would do with the new debt on offer.
This is easier to understand with an example.
Imagine a multifamily property that generates $200,000 annually. After expenses (excluding interest and taxes), the NOI is $50,000. Under the conditions of the loan, there is a debt obligation of $40,000 per year. That gives us a debt coverage ratio of 1.25x, meaning that the property could pay its debt obligation 1.25 times over with the profits generated annually.
If this same property had a debt obligation of $45,000 annually, the DCR drops down to 1.11x, meaning the property would be able to pay its debts 1.11 times over annually.
The rule of thumb for lenders is that a property should have a minimum DCR of 1.25x when the new debt is factored into the equation. If there is existing debt that would still be paid by the new investor owner, that existing debt needs to be added into the new debt to generate the true DCR.
Lenders want to know that a property would be able to cover its debt expenses well, even if they ran into some financial trouble over the year. A DCR of 1.25x gives enough wiggle room for payments to still be made even if the property’s NOI drops at any point.
As a potential investor, you can use the DCR to provide a quick answer as to whether a CRE investment is worthwhile or not. Set a benchmark DCR that you’re comfortable with, then calculate the DCR of properties you’re looking to invest in to see if they meet your standards.
Disadvantages of Using DCR
The main problem with DCRs is actually the same thing that makes them useful. They are a broad metric.
If you have a hardline stance about a property remaining above a certain DCR, you might miss out on fantastic value-add opportunities. Value-add usually doesn’t have a great DCR going in, but there’s room to improve the NOI by either increasing revenues or decreasing expenses.
A property’s DCR gives a quick look at its financial position and how it will be able to handle debt. However, you often have to look a little closer if you want to see the true potential of the deal.