The definitions that turn net operating income into covenant cash flow, the assumed amortisation that inflates debt service, and the Excel to check both.
Under a loan agreement, DSCR is not NOI divided by what you pay the bank. It is the agreement's defined net cash flow, with vacancy and management fees at contractual floors and reserves deducted, divided by debt service on an assumed amortisation schedule. On an illustrative $30,000,000 interest-only loan at 6.00 per cent, the borrower's ratio is 1.54x and the agreement's is 1.10x, below a 1.20x covenant.
Worked in full in How to Read a Real Estate Loan Agreement by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
A multi-let office building carries a $30,000,000 loan at a fixed 6.00 per cent, interest-only. The agreement contains a 1.20x debt service coverage covenant tested quarterly on trailing twelve months, and a cash management trigger at the same level. The asset manager reports NOI and interest. The lender's servicer reports something else. All figures are illustrative.
| Input | Actual | Agreement definition |
|---|---|---|
| Gross potential rent | $4,400,000 | $4,400,000 |
| Vacancy and credit loss | 2% | greater of actual and 5% |
| Operating expenses excluding management | $1,450,000 | $1,450,000 |
| Management fee, % of effective income | 2% | greater of actual and 3% |
| Replacement reserves | none | $75,000 |
| Normalised TI and leasing commissions | none | $150,000 |
| Debt service | interest only | 30-year amortisation at the note rate |
The borrower's version. Effective income is $4,400,000 less 2 per cent vacancy, $4,312,000. Less operating expenses of $1,450,000 and a 2 per cent management fee of $86,240, NOI is $2,775,760. Interest is $1,800,000. The ratio is 1.54x and looks comfortable.
The agreement's numerator. Vacancy is charged at the 5 per cent floor, $220,000, which takes effective income to $4,180,000. Management is charged at 3 per cent of that, $125,400. Then the two deductions NOI never carries: $75,000 of replacement reserves and $150,000 of normalised tenant improvements and leasing commissions. Underwritten net cash flow is $2,379,600, $396,160 below NOI.
The agreement's denominator. The covenant does not use the interest actually paid. It uses the annual payment that would amortise the full balance over 30 years at the note rate.
Debt service = 12 × Loan × (r/12) / [1 − (1 + r/12)−360] = 12 × 179,865 = 2,158,382
Excel: =PMT(6%/12, 360, -30000000)*12
DSCR = 2,379,600 / 2,158,382 = 1.10x
| Step | Cash flow | Debt service | DSCR | Change |
|---|---|---|---|---|
| NOI over interest-only debt service | 2,775,760 | 1,800,000 | 1.54x | |
| Vacancy at the 5% floor | 2,646,400 | 1,800,000 | 1.47x | −0.07 |
| Management fee at the 3% floor | 2,604,600 | 1,800,000 | 1.45x | −0.02 |
| Less replacement reserves | 2,529,600 | 1,800,000 | 1.41x | −0.04 |
| Less normalised TI and leasing commissions | 2,379,600 | 1,800,000 | 1.32x | −0.08 |
| Debt service on 30-year amortisation | 2,379,600 | 2,158,382 | 1.10x | −0.22 |
The single largest step is not a cash flow adjustment at all. Switching from interest to an amortising payment raises debt service from a 6.00 per cent constant to 7.19 per cent and removes 0.22 on its own. The cash flow adjustments together remove another 0.22. On NOI with amortising debt service the ratio would be 1.29x; on net cash flow with interest only, 1.32x. Each half of the definition looks safe alone.
The borrower's NOI can fall 22.2 per cent before its own ratio touches 1.20x. On the agreement's definition the building is already in breach, and the cash management trigger has sprung, on income that has not fallen at all.
To reach 1.20x on the agreement's basis, net cash flow must be $2,590,058, which is $210,458 more, an 8.8 per cent increase. Alternatively the loan must fall to the balance whose 30-year payment the existing cash flow covers 1.20 times: $27,562,314, a paydown of $2,437,686. The prepayment route is expensive for the reason set out in why prepaying to cure a covenant costs eleven times a deposit: a cure that moves the denominator has to move the whole balance, not the shortfall.
The agreement's DSCR depends on two numbers that are set at signing and rarely revisited: the rate used for the assumed amortisation and the vacancy floor. Some agreements use the note rate, others the greater of the note rate and a fixed constant.
| Rate used | Annual debt service | 2% floor | 5% floor | 8% floor |
|---|---|---|---|---|
| 5.00% | 1,932,558 | 1.30x | 1.23x | 1.17x |
| 5.50% | 2,044,040 | 1.23x | 1.16x | 1.10x |
| 6.00% | 2,158,382 | 1.16x | 1.10x | 1.04x |
| 6.50% | 2,275,445 | 1.10x | 1.05x | 0.99x |
| 7.00% | 2,395,089 | 1.05x | 0.99x | 0.94x |
Each 50 basis points on the assumed rate costs roughly 0.06 of coverage, and each 3 points of vacancy floor about the same. A borrower negotiating the definition at term sheet stage is negotiating the covenant level, whether or not the 1.20x figure moves.
The mistake is computing DSCR from the asset management report and calling it the covenant. NOI over interest paid is a useful operating metric, but the loan agreement never tests it. Read the defined terms in this order: the cash flow definition (which income is excluded, which expenses are floored, which reserves are deducted), the debt service definition (actual, assumed amortisation, or a stated constant), the test period (trailing twelve months, annualised quarter), and whether the same definition drives the cash trap. The second mistake is testing coverage alone: on this loan the debt yield on net cash flow is 7.93 per cent against 9.25 per cent on NOI, and the order in which covenants bite is shown in which loan covenant breaches first.
The book reads covenants, cash traps and cures as clauses with a price, and the free workbook for this case includes a one-page model of your own loan where these definitions can be overwritten.
Lenders commonly set minimums somewhere around 1.20x to 1.35x, illustratively, depending on asset type and leverage, but the number only means something with its definition. The same property in this example reads 1.54x on NOI over interest-only debt service and 1.10x on the agreement's net cash flow over 30-year amortising debt service, so a 1.25x minimum can be comfortable or already breached.
Because the covenant is meant to test whether the property could carry a fully amortising loan at maturity or on a refinancing, not whether it can pay the coupon today. On $30,000,000 at 6.00 per cent, interest is $1,800,000 a year, while a 30-year amortising payment is $2,158,382, a 7.19 per cent constant. That switch alone takes 0.22 off the ratio.
Most loan agreements test trailing twelve months of actual income and expenses, adjusted by the agreement's floors and reserves, at each quarterly test date. Some use annualised trailing three months for a property in lease-up. Here the trailing NOI is $2,775,760 and the covenant cash flow $2,379,600, a gap of $396,160 created entirely by definitions.
This article is one calculation from How to Read a Real Estate Loan Agreement. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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