In residential lending, the lender determines how much a borrower can afford by calculating his debt-to-income ratio – how much total monthly debt he has divided by his total monthly earnings. In commercial lending, a different ratio is used. The debt service coverage ratio is the commercial mortgage equivalent of the debt-to-income ratio.
What is Debt Service Coverage?
The debt service coverage measures how much a business owner or investor can afford to borrow for a commercial property based on how much income the property will generate. It is calculated by dividing the net annual income of the property by the annual commercial mortgage payment.
Unlike the residential mortgage where personal income is critical, the commercial debt service coverage ratio measures the income created by the property. When determining the net property income, mortgage lenders include the rental income that can be collected from tenants as well as any other related income. From that is subtracted any costs for property management and upkeep, like taxes, insurance, repairs, pest control feed, janitorial services and utilities. Once all of that is boiled down to a dollar amount and divided by the potential mortgage debt, the ratio should be 1.20 or higher to have a high likelihood of being approved. That number means that the property would generate enough income to cover the mortgage debts as well as provide a 20 percent buffer to help offset costs if the borrower defaulted.
Example of Debt Service Coverage
Here’s an example. A real estate investor wants to purchase a property that will cost her $40,000 a year in commercial mortgage principal and interest. In order to achieve the 1.20 debt service coverage ratio, the property will need to generate $48,000 a year (net income divided by mortgage debt).
For small business owners looking to invest in some land or workspace for their companies, understanding how to calculate the debt service ratio could mean the difference between being approved or refused for a commercial loan.