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In this video, I will show you everything you need to know about the debt service coverage ratio and why understanding this concept is critical for you in dealing with a bank and getting either a business loan or a real estate loan.
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Hey everybody, as I said at the beginning, the debt service coverage ratio is an underwriting term used by banks when they are looking into giving you a loan. This concept is critical that you understand it. There are other concepts that we’ll cover in other videos like day’s cash on hand, debt to equity ratio, or current ratio, subjects for other videos. But for today’s video, we’re talking about what the definition is and what it means to you, and how you can know for sure that you’re going to pass the test with the bank.
So it’s a simple formula. It’s deceptively simple. So debt service coverage ratio equals net operating income divided by debt service. Now, net operating income can be net income just from a profit and loss. It could be earnings before interest tax over debt service, or it can also be EBITDA over debt service. So earnings before interest taxes, depreciation, and amortization.
So either of those three, it is what has been agreed by you and the bank as to what the definition is. It all begins with the right definition. I always tell my clients opt for an EBITDA definition. EBITDA. It’s critical because you get your interest taxes, depreciation and amortization added back to your calculation. Anyway, so it’s net operating income divided by debt service.
So each bank is different. I’ve seen debt service coverage ratio as 1.20, which means you have to have 20% more net income than you do debt service. It could be 1.25. It could be 1.30. Now as the situation is fluid with the markets right now where we are in the middle of a pandemic, this is what’s going on. So I’ve seen this ratio go from 1.2 or to 1.25. For the sake of this video, it’s going to be 1.25.
So for instance, if you want to know your max debt service, it’s net operating income divided by 1.25. So in this example, if you have a net operating income of 100,000, if you follow that formula, if you divide that by 1.25, your maximum debt service per year cannot exceed 80,000 or $6,667 per month. That’s a combination of principal plus interest, which I should have said at the beginning, NOI over debt service is comprised of interest payments plus principal reduction payments. So you know that your maximum debt service is going to be your net operating income divided by 1.25.
Now your ideal net operating income, in this case it would be the reverse. If you know that your yearly payments are 80,000, then what you do is you take that debt service times 1.25, and it’s going to give you the opposite. It’s going to give you the ideal net operating income.
Let’s go over a real example now. A $1.2 million real estate loan at 7% APR amortized over 25 years makes for an $8,317 a month, monthly payment of principal and interest. And there’s roughly about 99,804, so basically a $100,000 a year of debt service. What must you have minimum net operating income in order for you to not be in violation of your covenant? So you take the 99,804 times 1.25 I talked about earlier, and that will back us into what the minimum net operating income, which works out to the 1.25. Roughly about $125,000 a year.
Now, when I mean minimum, it is the minimum. You don’t want to shoot for a loan that barely covers that. You need to shoot for at least that, but a whole lot more. You need to probably overshoot it so in case something bad happens. So say, for instance, you need a pretty income, did not allow for vacancies. Instead of having a 5% vacancy, you have a 10% vacancy, or even a 15% vacancy. Then your NOI is not going to hit the milestone that the bank wants. Usually the debt covenants with the bank are revised every year at the end of the fiscal year. So if your fiscal year ends 12/31, then before the end of the first quarter of the following year, you have to be able to produce this financials. And depending on the size of the deal, maybe have to be audited financials, compiled, or reviewed financials from an outside party, a third party preparer like a CPA.
So what if instead of 1.25, our debt service coverage ratio was 1.20? What would the minimum net operating income be? You guessed right. It would be lower. In this case, it will be 119,764. So less, right? Less debt coverage. This is basically a buffer. In this case, the bank is saying, “I want you to have at least 25% more net operating income than you do debt service.” Here, when times are booming, banks are a little more lenient, so they’re going to lower the year overage. So in this case, it’s going to be 20% cashflow over debt service.
Well, what if the opposite is true? What if instead of having a 7% APR, your credit is not that great, you didn’t have a perfect score, something happened with the deal. You got stuck with an 8.5% APR. What will your net operating income be? In this case, it’s going to be $141,150 per year. This makes a big difference. This makes a big difference in how you plan your deal. So you need to understand this. That’s why banks put so much emphasis on the debt service coverage ratio. Not a conversation goes by in which this topic comes up with the bank. And before they even issue a term sheet, they already have looked at your numbers and they know that you have at least that, if not better. So my word of advice is plan for something higher, like a 1.3, a 1.4 so if you miss the mark, you’ll still be landing at the minimum debt service coverage ratio.
Thanks so much for watching. Please comment below and let me know if this concept has come up with you in dealing with a bank and what the outcome was. Also, if you want to join a community of like-minded successful entrepreneurs just like you, then join our Facebook group at the link below where I share tips, tactics and strategies on a weekly basis on how my clients are growing their businesses to seven figures and beyond.
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