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Not all Debt Service Coverage (DSC) covenants are created equal. Ignore that truth, and you might find yourself in default without even realizing it.
After working on countless deals across asset classes and markets, I have seen how even seasoned investors can trip up on the nuances of DSC covenants – costing time, money, and credibility with lenders. Understanding DSC deeply is not just a “nice-to-have” – it is essential because it shows not only the level of cash flow of the deal but also lenders would lean on it to size up the loan.
The Minimum Threshold: It Is Not One-Size-Fits-All
Many investors assume 1.25x is the standard minimum Debt Service Coverage ratio. But the truth is, it can vary – anywhere from 1.00x to 1.50x – depending on the borrower’s risk profile, the market dynamics, the deal’s structure (e.g. leverage), and the asset class.
Bottom line: The more risk the lender perceives, the higher the DSC requirement you will likely face.
What Lenders Really Review At Inception
When underwriting a deal, lenders are not just taking your proforma at face value.
Especially in value-add or heavy-lift deals, they will dig into both your actuals and projections. More importantly, they will run their own base case and downside case proformas to ensure that projected Year 1 DSC levels meet their covenant minimums.
Translation: You need to be just as critical of your numbers as your lender will be.
Definition Matters: DSC Is Not Always What You Think It Is
Here is where many borrowers get caught off guard:
Not every lender uses the textbook DSC formula of NOI ÷ Debt Service.
Depending on the lender, DSC could be defined as:
- NOI ÷ Principal + Interest (traditional definition)
- NOI ÷ Interest Only or NOI ÷ Imputed Principal + Actual Interest (IO loans)
- Adjusted NOI (adjusted for lender-selected cash flow items) ÷ Debt Service
- Rent ÷ PITIH (Principal, Interest, Taxes, Insurance, HOA)
The key: Your loan agreement spells it out. Never assume – always verify.
Compliance Starts With Clarity
Understanding how your lender defines DSC is not just an academic exercise – it is vital to staying in compliance over the life of your loan.
If you do not know exactly how it is calculated, refer to your loan agreement. You might think you are safe… until you are not.
Actionable Insights:
Before you sign a loan agreement:
✅ Confirm the lender’s exact definition of DSC
✅ Stress test your projections using base and downside cases
✅ Understand what triggers a covenant breach – and how to cure it
✅ Align your internal asset management practices with lender reporting requirements
Debt Service Coverage is more than a number – it is a lifeline to your lender relationship. Master it, and you will not just protect your downside. You will position yourself as a borrower who truly “gets it” – and that is a rare and valuable thing in today’s lending environment.
Vessi Kapoulian
Breaking down multifmaily underwriting one step at a time to create educated and empowered investors
PS: Want hands-on help mastering deal analysis? Send me a DM to learn how you can join our Underwriting Community, which also includes a self-paced course and live monthly coaching to help you become an underwriting pro. Our next call is coming up, and you do not want to miss it!