DSCR stands for “Debt-Service Coverage Ratio.” It is a measure of the ratio of income (specifically, Net Operating Income) to debt (Total Debt Service). Investors will use this to work out what the margin of safety is between the expense of paying back the bank and the total rent they receive.
What is DSCR used for?
Lenders calculate the DSCR to decide whether or not to loan money to someone (a company, a real estate investor, etc.). A high DSCR indicates that it is an acceptable risk to loan them money; a low DSCR shows that it is probably better not to lend them money. Shareholders also use the DSCR to know whether or not a company is solvent and how much so, for use in their decision-making process.
How is the DSCR calculated?
DSCR is calculated by dividing the Net Operating Income (NOI) by the Total Debt Service (TDS) over a certain period of time, for example, a year.
How is NOI calculated in the case of real estate investment? Add up rental income, key money, renewal fees, etc. Then subtract Certain Operating Expenses. Examples of Certain Operating Expenses include condominium fees, property tax (literally “Fixed Asset Tax,” or 固定資産税, koteishisanzei), etc.
For example, imagine that a real estate investor named Haruto owns several units in the same building, and rents them out. He receives ¥300,000 per month in rental income. However, condo fees cost ¥82,000 per month, and property tax costs ¥300,000 per year. Here is how we calculate his NOI:
(¥300,000 per month rental income – ¥82,000 per month condo fees) × 12 months in a year – ¥300,000 per year in property tax = ¥2,316,000←NOI
TDS consists of mortgage payments, payments into (a) sinking fund(s), etc. Sinking funds (Japanese: 修繕積立金, shūzen tsumitate kin) will be explained later (the sinking fund, although not a debt, is a financial obligation, so many people include it in the calculation).
For instance, imagine that Haruto has a mortgage on his property, and his property is worth ¥20,000,000. It is a 20-year mortgage, so each year, he pays ¥1,000,000 towards the principal, and the interest rate on the mortgage is 1%, so he pays ¥200,000 each year for that. He also pays ¥200,000 each year into a sinking fund. Let’s calculate his TDS:
TDS = ¥1,000,000 towards the principal of the mortgage + ¥200,000 paid in mortgage interest + ¥200,000 paid into a sinking fund
TDS = ¥1,400,000
What is Haruto’s Debt Service Coverage Ratio, then?
DSCR = ¥2,316,000 ÷ ¥1,400,000
DSCR = 1.65
Congratulations, Haruto! You have a very good DSCR of 1.65, and it will be much easier for you to get a loan.
What DSCR numbers are good and bad?
First of all, any number less than 1 is not good, because that indicates that, basically, debt exceeds income. It is very unlikely that a financial institution will loan money to someone with less than 1. If the economy is good or if the lender has some credible reason to believe that something will happen soon to improve the potential borrower’s financial situation, a loan might be possible with 0.95, but anything less than 1 shows the lender that currently, the real estate investment, business, etc. is operating at a loss. 1.2 is good, but these days, many lenders feel that 1.6 is preferable, with 2.0 being great.
What is a sinking fund?
A sinking fund is an amount of money put away at regular intervals to prepare for a major expense down the road. For example, a condo owner might not have had to make any repairs last year, or the year before that. However, this year, his fusebox suddenly broke down, and left him without electricity. He has to pay ¥21,000 to have the fusebox repaired. What if he does not have ¥21,000? Then he will just have to wait until he does—hopefully he does not mind cold showers or candles. To prevent this scenario from unfolding, he should have put away a certain amount of money every year in a sinking fund; he should have put away, for instance, ¥20,000 per year towards home repairs. If he had done so, he would have at least ¥60,000 in the sinking fund by now, and could just call (and pay) an electrician to fix his fusebox.
Sinking funds are a wise idea for a real estate investor or any business venture, really. For example, companies that issue bonds have sinking funds for bond repayment. It is better to prepare beforehand than it is to scramble around at the last minute trying to come up with the funds.
By now, we have a pretty good understanding of the basics of DSCR (Debt Service Coverage Ratio). It is a number used by potential lenders (e.g. banks or other financial institutions) or investors to figure out if it is worth it or not to loan money to, or invest in a business venture (e.g. real estate investment). It is calculated by dividing NOI (Net Operating Income) by TDS (Total Debt Service). NOI is all the income generated over a period of time minus the Certain Operating Expenses. TDS is the sum of repayments for the principal of a mortgage, mortgage interest, contributions to sinking funds, and any other ongoing liabilities or financial preparations in case liabilities arise. This ratio takes the form of a decimal number. Any number 1 or higher is good, but 1.2~1.6 are preferable, especially 1.6+, these days; 2 is great.