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FAQ

- What is a debt service coverge ratio?

The debt service coverage ratio, or debt service ratio, is the ratio of operating income to debt payments on a piece of investment real estate. The higher this ratio is, the easier it is to borrow money for the property. The phrase is also used in corporate finance and may be expressed as a minimum ratio that is acceptable to a lender; it may be a loan condition, a loan covenant, or a condition of default.

1. In corporate finance, it is the amount of cash flow available to meet annual interest and principal payments on debt, including sinking fund payments.

2. In government finance, it is the amount of export earnings needed to meet annual interest and principal payments on a country's external debts.

3. In personal finance, it is a ratio used by bank loan officers in determining income property loans. This ratio should ideally be over 1. That would mean the property is generating enough income to pay its debt obligations.

In general, it is calculated by: DSCR = Net Operating Income / Total Debt service

A DSCR of less than 1 would mean a negative cash flow. A DSCR of less than 1, say .95, would mean that there is only enough net operating income to cover 95% of annual debt payments. For example, in the context of personal finance, this would mean that the borrower would have to delve into his or her personal funds every month to keep the project afloat. Generally, lenders frown on a negative cash flow, but some allow it if the borrower has strong outside income.

Typically, most commercial banks require the ratio of 1.15 - 1.35 times (net operating income or NOI / loan amount) to ensure cash flow sufficient to cover loan payments is available on an ongoing basis.

- What is a cap rate?

A Capitalization Rate (or "Cap Rate") is a measure of the ratio between the net income produced by an asset (usually real estate) and its capital cost (the original price paid to own the asset). The rate is calculated in a simple fashion as follows:

• Net Income / Capital Cost = Capitalization Rate

For instance, if a building is purchased for $1,000,000 sale price and it produces $100,000 in positive net cash flow (the amount left over after fixed costs and variable costa are subtracted from gross lease income) during one year, then:

• $100,000 / $1,000,000 = 0.10 = 10%

That asset's capitalization rate is ten percent.

Capitalization rates are a measure of how fast an investment will pay for itself in net cash flows. In the example above, the purchased building will be fully capitalized (pay for itself in net income) after ten years.