The formula
Coverage is cash flow divided by debt service. Debt service is twelve monthly payments. The monthly payment on a loan that fully amortizes is the loan times r, divided by one minus (1 plus r) to the power of minus n, where r is the monthly rate (the annual rate divided by 12) and n is the number of months.
Two loans with the same payment on the same cash flow have the same coverage. Coverage is a statement about the payment, not about the property.
What goes in the cash flow
The SBA defines the measure for its loans. In a change of ownership, historical coverage is earnings before interest, taxes, depreciation and amortization divided by the combined debt service after the transaction. For a 504 loan the development company must prepare a global cash flow and justify each addition and subtraction, such as rent payments, unfunded capital spending, non-recurring income and distributions.
For a conventional loan the lender's own policy decides which expenses, reserves and vacancy it counts, so the cash flow a lender uses is often not the one on the owner's statement. Ask for the lender's definition in writing before you size a request around a ratio.
The minimums SBA publishes
A bank's minimum coverage is its own loan policy, and it is not published. The interagency real estate lending guidelines (12 CFR part 365, Appendix A) tell each bank to set minimum standards for net worth, cash flow and debt service coverage in its own policy, and give no numbers. SBA does publish its minimums, in SOP 50 10 8.1:
| Loan | Minimum | Basis |
|---|---|---|
| Standard 7(a), over $350,000 | 1.15x | Historical or projected cash flow, and 1.00x on a global basis |
| 7(a) Small Loan, not a change of ownership | 1.10x | Historical or projected |
| Change of ownership: initial acquisition, owner buyout, ESOP, cooperative | 1.25x | Last fiscal year or the average of the last two |
| Change of ownership: business expansion | 1.15x | Last fiscal year or the average of the last two |
| 504 | 1.15x | Historical, last fiscal year or the average of the last two |
For a start-up or any request that relies on projections, SOP 50 10 8.1 asks for projections that reach 1.15x within two years of funding, or within two years of the end of construction. Debt service in the 7(a) test means the future required principal and interest on all business debt, including the new SBA loan.
Using it well
- Test at the lender's terms. Use the rate and amortization the lender will size on, not the ones you hope for. A quoted rate can sit below the rate a lender uses to test coverage.
- Read the cushion. Coverage of 1.42x means cash flow can fall about 30 percent before the payment is no longer covered. That cushion is what a lender is buying.
- Size the loan, not only the deal. If coverage is short, the maximum loan calculator shows the loan that does work, and which test sets it.
In the data here
No public file carries a debt service coverage ratio. Call reports hold balances, HMDA holds the amount, rate, term and loan to value as filed, and the SBA files hold the loan and its processing method. Coverage lives in the lender's credit file. The lender page shows what a lender holds and has made, so you can find lenders at your size, and the lender tells you the rest.
Terms used here
- Debt service coverage ratio (DSCR): Net operating income, or business cash flow, divided by the loan payments due in a year. It shows how many dollars come in for each dollar of debt service.
- Net operating income (NOI): A property's annual income minus its operating expenses, before loan payments, income taxes and depreciation. It is the top number in DSCR and debt yield.
- Loan constant: One year of loan payments divided by the loan amount, shown as a percent. It folds the interest rate and the amortization period into a single number.
Sources
Next step: check the record
- Find lenders by the kind of loanFilter every bank and credit union by the kinds of loans it holds, the size and the state.
- Loan CompsDescribe the deal and see which lenders have made loans like it.
Keep reading
- How bankers evaluate a commercial loan deal: A credit officer asks one question five ways: how will this loan be repaid, and what happens if it is not? Knowing the five tests lets you size a request before you send it.
- Global cash flow, explained step by step: A property can cover its loan while the people behind it cannot cover their other debts. Global cash flow is the test that looks at all of it at once.
Estimate from your inputs. Not a quote or advice about which loan to take. Another tool: all calculators.