In recent articles, some of the criteria and analyzes that go into determining the feasibility of a commercial mortgage loan have been discussed. We’ve looked at how we arrived at the net operating income or NOI of a building. This is key, because it tells us how much, after expenses, the building earns. And remember, in a commercial loan the key is what the building earns. This is why buildings next to each other with the same number of shops and apartments above can be worth two different amounts. Different levels of NOI! We’ve looked at the capitalization rate, or the return a commercial property buyer wants to get on his or her investment. We show how this number, along with the NOI, can give us an idea of ​​what a building is worth.

Debt Service Coverage Ratio or DSCR

Now let’s look at the most important number, the number that will go a long way in determining whether or not a commercial mortgage loan can be financed. It is a number that can reduce the amount of the loan, or even potentially increase it. This number is the debt service coverage ratio, or DSCR. Remember what we said earlier in Article 1. Commercial mortgage loans are not about LTV, they are about DSCR.

DSCR is not a complicated formula, but it will tell us whether the debt service (principal + interest) on a given loan amount at a given interest rate will be adequately covered by the NOI produced by the building. Again? Will the annual NOI divided by the annual debt service coverage of the desired loan result in a high enough DSCR to satisfy the lender? Generally, the minimum DSCR level will be 1.20X or 1.25X depending on the type of property.

Remember that the mortgage rate cannot be higher than the capitalization rate, or the building will not pay the debt. Another way to look at it: You can’t borrow money from Bank 1 at 7% and invest it in Bank 2 at 6%. This is not a winning proposition and in terms of commercial mortgages you will not get the DSCR you need.

Now let’s take a look at an example. Remember that the calculations are not complicated, but the results are critical to the success or failure of loan financing:

NOI = $80,000 Annual Mortgage Expense = $65,000

DSCR = $80,000/$65,000 = 1.23X, which is fine for certain property types

What happens if the NOI goes down or the mortgage expenses go up?

NOI = $75,000 Annual Mortgage Expense = $68,000

$75,000/$68,000 = 1.1X DSCR which is not a good number.

One way around this is a lower loan amount which will result in a lower mortgage expense. This will require a larger down payment for a purchase or lower income in the event of a refinance.

In any case, the conclusion remains that:

Income-producing property must be able to support itself!