Understand the Ins and Outs of the Popular Lending Tool
By Dan Dempsey and Joanna Stevens
A DSCR loan refers to a loan where the primary consideration is the Debt Service Coverage Ratio. The lender pays close attention to the borrower’s ratio to assess creditworthiness and ability to manage debt. The DSCR is a financial metric used to assess a borrower’s ability to cover debt payments with operating income and is commonly used in commercial real estate and for business loans. Below is a breakdown of the primary aspects of a DSCR loan:
Debt Service Coverage Ratio and Its Purpose
This ratio is calculated by dividing a borrower’s net operating income by their total debt service. Total debt service includes principal and interest payments. For example, if a business has an NOI of $120,000 and debt payments of $100,000, the DSCR would be 1.2.
Lenders use DSCR to evaluate the risk associated with lending to a borrower. A DSCR greater than 1.0 means the borrower can cover debt obligations. A ratio less than 1.0 indicates possible payment struggles. For commercial real estate loans, lenders usually require a minimum DSCR of 1.2. This ensures the property generates enough income to cover payments.
Advantages of a DSCR Loan
Focus on Cash Flow
DSCR loans focus on cash flow rather than just credit score or collateral. They can be accessible to borrowers with strong income but limited assets or imperfect credit.
Predictable Requirements
The DSCR requirement is a simple metric that clarifies the income needed for a loan. It helps borrowers plan their finances effectively.
Flexibility in Use
These loans can fund commercial real estate acquisitions, business expansion, or refinancing, as long as income covers the debt service.
Risk Mitigation
A higher DSCR requirement can mitigate risk for both borrowers and lenders. It ensures that there is a buffer for unexpected fluctuations in income.
Disadvantages of a DSCR Loan
Higher Requirements
Loans with high DSCR requirements might be challenging to qualify for, especially for businesses or properties with fluctuating or lower than average income streams.
Income Sensitivity
If a borrower’s income goes down, it might affect their DSCR and their ability to pay back the loan. This could lead to refinancing challenges or higher costs.
Potential for Higher Rates
Some lenders might offer higher interest rates for loans where DSCR is a primary consideration, to account for the risk of income variability.
Complex Evaluation
Assessing DSCR requires thorough analysis of financial statements and projections. Missing financial statements can make these evaluations difficult or nearly impossible.
Term Length and Amortization
DSCR loans often have terms from five to 20 years, the most common terms being five to 10 years. But, based on property specifics and the lender agreement, the term can be longer. The amortization period, which is the time it takes for the loan to be repaid, might be longer than the term. For example, a 10-year loan might have a 20- or 25-year amortization period dependent on cash flow.
Interest rates can be fixed or variable, and there may be prepayment penalties. Some loans might require a balloon payment at a specific time. There are different approaches, and much of the value in this type of loan is its flexibility and the reduced number of documents required when closing or refinancing.
Dan Dempsey joined NAI Iowa Realty Commercial in early 2022 after years of building his own personal portfolio. His area of focus is in investment properties, with expertise in multifamily properties. Being a real estate investor himself, Dempsey enjoys working with investor-clients to help them determine and meet their real estate needs now and as the portfolio grows. As one of the most recognizable names in the mobile home park industry, Joanne Stevens is consistently sought out to provide her expert market insight to a wide range of audiences. Stevens is a real estate agent with more than 15 years of experience of listing and selling mobile home parks.
