Debt Service is the total principal and interest payment owed on a financial obligation, such as a commercial mortgage loan, expressed on an annual basis.
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Debt service in the real estate industry refers to the burden placed on a borrower after committing to a financing arrangement.
The borrower is contractually obligated to service periodic interest and principal payments to the lender once the lending agreement has been formally signed by both parties – including the repayment of the original principal in full at maturity.
From the perspective of commercial lenders, such as banks, debt service is one of the most critical factors to consider when underwriting a loan.
The borrower of a commercial mortgage loan must service its interest and principal payment obligations on time, per the lending agreement.
Otherwise, the borrower is at risk of defaulting on the commercial loan and becoming insolvent. In the event of default, the lender most likely would have the right to seize the property based on the terms as outlined in the original agreement to recoup any monetary losses.
Senior lenders normally require the borrower to pledge the underlying real estate property as collateral to further protect their downside risk (i.e., a lien).
While the borrower is held liable in the event of default, the lender must still actively mitigate risk by performing in-depth diligence on the credit profile of the borrower (and property).
Debt service comprises the periodic principal amortization and interest owed on a loan.
The formula to calculate the annual debt service is the sum of the principal payment and interest expense in a specified period.
Annual Debt Service = Principal + InterestIn practice, the annual debt service is most often calculated in Excel, as part of building a loan amortization schedule.
The amortization schedule is a method used to track and calculate the periodic principal amortization and interest owed on a loan, including the outstanding loan principal balance.
The annual debt service can be determined via the built-in PMT function in Excel, which calculates the periodic payment on a loan, inclusive of the interest and principal component.
=PMT(rate, nper, pv, [fv], [type])The two components of the annual debt obligation — the principal and interest payments — can be separately calculated using the PPMT and IPMT function, respectively.
=PPMT(rate, per, nper, pv, [fv], [type]) =IPMT(rate, per, nper, pv, [fv], [type])The sum of the principal and interest computed using the PPMT and IPMT function must equal the debt service determined by the PMT function, or else a mistake was likely made.
Maintaining consistency in the units is critical to ensure the accuracy of the payment amounts (i.e. monthly, quarterly, semi-annual, annual).
Note: The PMT, PPMT and IPMT Excel functions each assume a fixed interest rate pricing structure on the loan.
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The debt service ratio – more commonly known as the “debt service coverage ratio (DSCR)” – is used by commercial lenders to determine if a property can generate enough income to fulfill its debt obligations.
The debt service ratio is a credit risk underwriting metric that compares the net operating income (NOI) of a rental property to its annual debt service.
The formula to calculate the debt service ratio divides net operating income (NOI) by the annual debt service.
Debt Service Ratio = Net Operating Income (NOI) ÷ Annual Debt ServiceThe DSCR is one of the credit metrics relied on in commercial lending to measure the debt capacity and credit risk of a particular borrower.
Lenders often establish parameters on the loan amount based on the insights derived from the DSCR metric, as part of the loan underwriting process.
In the commercial real estate (CRE) market, the standard minimum DSCR is 1.25x. However, the minimum DSCR is conditional on the current macroeconomic environment and state of the credit markets.
By setting a minimum DSCR in the financing arrangement, lenders can ensure the borrower’s cash flow is sufficient to meet the periodic interest and principal repayment obligations.
We’ll now move on to a modeling exercise, which you can access by filling out the form below.
Suppose we’re tasked with calculating the debt service of a proposed request for a commercial mortgage to measure the riskiness of partaking in the financing arrangement.
The borrower, a commercial real estate (CRE) investment firm, submitted the following pro forma financial data as part of the application process.
| Rental Property – Pro Forma Data | Year 1 |
|---|---|
| Gross Potential Rent (GPR) | $2,400k |
| (+) Ancillary Income | 200k |
| Potential Gross Income (PGI) | $2,600k |
| (–) Vacancy and Credit Losses (5.0% of PGI) | (130k) |
| Effective Gross Income (EGI) | $2,470k |
| (–) Direct Operating Expenses (40.0% of EGI) | (988k) |
| Net Operating Income (NOI) | $1,482k |
The requested 30-year commercial loan amount is $14 million priced at an interest rate of 7.5%.
Given those set of financing assumptions for the commercial loan, the next step is to insert each figure into the PMT function in Excel.
=PMT(G14,G15,G13)
The annual debt service is approximately $1.2 million, which we’ll confirm by calculating the principal and interest components separately.
The principal payment comes out as $135k, whereas the interest payment is $1,050k.
Combined, the total debt service for Year 1 matches our earlier calculation.
In the final section of our tutorial, we’ll conclude by calculating the debt service ratio (or DSCR).
The net operating income (NOI) of the commercial property is projected to be $1.482 million while the annual debt service is $1.185 million.
By dividing the property’s NOI by the annual debt service, we arrive at a debt coverage ratio of 1.25x.
