A commercial property has an annual NOI of $85,000 and annual debt service of $65,000. What is the debt coverage ratio?
Correct Answer
A) 1.31
Debt coverage ratio = NOI ÷ Annual debt service = $85,000 ÷ $65,000 = 1.31.
Why This Is the Correct Answer
Option A is correct because the debt coverage ratio is calculated by dividing the Net Operating Income by the annual debt service. Using the formula: DCR = $85,000 ÷ $65,000 = 1.307, which rounds to 1.31. This calculation follows the standard industry formula where NOI is the numerator and debt service is the denominator. The result of 1.31 indicates the property generates 31% more income than needed to cover debt payments.
Why the Other Options Are Wrong
Option B: 0.76
Option B (0.76) represents the inverse calculation of debt service divided by NOI ($65,000 ÷ $85,000), which is incorrect and would indicate the property cannot cover its debt obligations.
Option C: 1.24
Option C (1.24) appears to be a miscalculation or rounding error, possibly from using slightly different numbers or an incorrect formula application.
Option D: 0.81
Option D (0.81) is also an inverse-type calculation error that would incorrectly suggest the property has insufficient income to cover debt service.
NOI Over Debt = Safety Net
Remember 'NOI OVER DEBT' - Net Operating Income goes on top (numerator), Debt service goes on bottom (denominator). Think of it as 'income covers debt' - the bigger number (income) should be on top to show coverage.
How to use: When you see a DCR question, immediately identify the NOI and debt service amounts, then remember 'NOI OVER DEBT' to set up the fraction correctly with NOI as the numerator.
Exam Tip
Always double-check that your DCR result makes logical sense - if NOI is higher than debt service, your ratio should be greater than 1.0, and vice versa.
Common Mistakes to Avoid
- -Inverting the formula by putting debt service over NOI
- -Using gross income instead of net operating income
- -Forgetting to include all components of annual debt service (principal and interest)
Concept Deep Dive
Analysis
The debt coverage ratio (DCR) is a critical financial metric used by lenders and appraisers to evaluate a commercial property's ability to service its debt obligations. This ratio measures how many times the property's net operating income can cover the annual debt service payments. A DCR above 1.0 indicates the property generates sufficient income to cover debt payments, while below 1.0 suggests potential cash flow problems. Lenders typically require a minimum DCR of 1.20-1.25 for commercial loans to provide a safety margin.
Background Knowledge
Net Operating Income (NOI) represents the property's annual income after operating expenses but before debt service and taxes. Annual debt service includes both principal and interest payments on the mortgage loan. The debt coverage ratio is a key underwriting criterion that lenders use to assess loan risk.
Real-World Application
Appraisers use DCR analysis when valuing income-producing properties for lending purposes, helping determine if the property can support proposed financing and assisting in loan-to-value ratio decisions.
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