Minimum Debt Coverage Ratio
The debt coverage ratio is the ratio of a company's available cash to cover financial obligations such as interest payments, principal and lease payments. The higher the ratio, the greater a company's ability to make it payments to keep operations going. Conversely, a low ratio places the company at a higher financial and operating risk. In general, lenders like to see a debt service ratio above 1.0 times.
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Calculation
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The debt coverage ratio is also referred to as the debt service ratio (DSC) and is an important ratio, particularly in the commercial mortgage lending business. It is calculated as (annual net income + amortization/depreciation + interest payments + other non-cash and discretionary items (such as non-contractual management bonuses)) / (principal repayment + interest payments + lease payments). The DSC is a good indicator of a business' financial strength.
Interpretation
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Banks and other commercial lenders look at the DSC when considering extending credit. A higher ratio means that a company has sufficient cash to meet it current obligations, which means less financial risk. The DSC requirement will vary from lender to lender depending on their risk tolerance. Some lender may require a DSC of 1.35 times while others may extend credit to borrowers with a DSC as low as 1.10 times. A ratio of 1.25 times means that the borrower is earning 25 percent more than it needs to service its financial obligations.
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Commercial Mortgage-Backed Securities
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Usually commercial loan originators such as banks pool these mortgages together and sell them to investors known as commercial mortgage-backed securities. The credit rating agencies provide their risk assessment of pooled commercial mortgage loans by assigning a triple-letter grade such as AAA (the highest rating), based on the quality of the loans. The DSC plays an important role in ratings. A DSC of less than 1.0 times may garner a ratings downgrade. A DSC less than 1.0 times means that rental income from the commercial property is insufficient to the mortgage debt.
Considerations
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For investors in commercial mortgages, an important thing to consider is the rate of deterioration of a pool of commercial mortgages. For example, a pool of 200 mortgages may have a weighted-average DSC of 1.78 times; however, it may contain 10 mortgages that are "underwater" (a DSC of less than 1.0 times). A further investigation should incorporate the rate of deterioration. A high rate of deterioration is a red flag on the quality of commercial mortgage originator's underwriting standards.
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