The debt service coverage ratio measures the ability of a revenue-producing property to pay for the cost of all related mortgage payments. In essence, it compares cash flows to debt service payments. A positive debt service ratio indicates that a property’s cash flows can cover all offsetting loan payments, whereas a negative debt service coverage ratio indicates that the owner must contribute additional funds to pay for the annual loan payments.
A very high debt service coverage ratio gives the property owner a substantial cushion to pay for unexpected or unplanned expenditures related to the property, or if market conditions result in a significant decline in future rental rates.
To calculate the ratio, divide the net annual operating income of the property by all annual loan payments for the same property. The formula is:
Net Annual Operating Income ÷ Total of Annual Loan Payments
For example, a rental property generates $400,000 of cash flow per year, and the total annual loan payments of the property are $360,000. This yields a debt service ratio of 1.11, meaning that the property generates 11% more cash than the property owner needs to pay for the annual loan payments.
An issue regarding this ratio is that a negative outcome can result when a property is transitioning to new tenants, so that it is generating sufficient cash by the end of the measurement period, but was not doing so during the beginning or middle of the measurement period. Thus, the metric can yield inaccurate results during transition periods.