Debt Service Coverage Ratio

Arguably the most important of the financial ratios used to underwrite commercial mortgage loans is the debt service coverage ratio.  The debt service coverage ratio is defined as the net operating income divided by the proposed debt service (NOI / Debt Service).  Let's now describe this ratio is plain, everyday English.

Real estate investors customarily prepare an annual budget for income properties.  This budget is called a Pro Forma Operating Statement.  It starts with the gross scheduled rents, and then it sets aside a little money for vacancy and collection loss.  After all, the owner is likely to have the occasional vacancy; and even if he doesn't have any vacancies, he's likely to lose some dough due to bad checks and tenants skipping out on the rent.  Therefore its customary for an investor to set aside 5% of the gross potential income for vacancy and collection loss.

The net operating income (NOI) in the above equation is the annual net income from the property, after some money is set aside to replace the roof, resurface the parking area, and to replace the HVAC units.

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