What Is Interest Coverage Ratio?

Interest Coverage Ratio (ICR) is a key financial assessment tool used by lenders to determine your commercial loan borrowing power. Understanding this metric is crucial for commercial property investors looking to maximize their financing potential.

ICR is a financial metric that lenders use to assess your ability to service a loan's interest payments. Simply put, it measures how many times over your property or business's income can cover the interest expenses on your debt.

This measurement is particularly important when applying for commercial loans, as it helps banks determine your risk level and borrowing capacity.

ICR Formula

Interest Coverage Ratio = Earnings Before Interest and Taxes (EBIT) / Interest Expense

Why Interest Coverage Ratio Is Popular

ICR has become a preferred assessment method for commercial property loans due to several key advantages:

1. Simplicity: ICR provides a straightforward calculation that's easy to understand for both lenders and borrowers
2. Focus on servicing ability: It directly measures your ability to meet interest obligations
3. Industry standard: Many major banks and lenders use ICR as their primary commercial loan assessment metric
4. Realistic assessment: It accounts for both your personal and investment income streams

How ICR Compares To Other Financial Metrics

ICR vs. Net Surplus Ratio (NSR)

While ICR focuses solely on your ability to service the interest component of a loan, Net Surplus Ratio (NSR) takes into account both interest and principal repayments. NSR provides a more comprehensive view of your total repayment capacity.

ICR vs. Debt-Service Coverage Ratio (DSCR)

Debt-Service Coverage Ratio (DSCR) is similar to NSR, as it also considers principal repayments along with interest. The key difference is that DSCR typically focuses on the property's income alone, rather than including other income sources.

Interest Coverage Ratio

Focuses on interest payments only

Net Surplus Ratio

Considers both interest and principal repayments

Debt-Service Coverage Ratio

Focuses on property income for total debt service

How Banks Calculate ICR

When calculating your Interest Coverage Ratio, banks will include various income sources and deduct certain expenses to determine your true repayment capacity.

Income Sources Included

1. PAYG income: 100% of your base salary
2. Rental income from investment properties: 80%
3. Income from commercial assets: 65% for landlord-covered outgoings, 85% for tenant-covered outgoings

Expenses Deducted

1. Interest payable from your commercial loan using specific assessment rates
2. Interest and principal amounts owed in your existing loans

Important Note

Banks will always include all of your existing debts when calculating your ICR, even if you're planning to pay them off with the new loan. This ensures a conservative assessment of your repayment capacity.

How ICR Is Applied in Loan Assessment

When assessing your commercial loan application, lenders will apply specific ICR thresholds based on several factors:

1. Property type: Different ICR requirements for retail, office, industrial, and specialized properties
2. Lease terms: Longer leases with quality tenants may receive more favorable ICR requirements
3. Location: Prime locations may have different ICR thresholds compared to regional areas
4. Loan-to-Value Ratio (LVR): Higher LVR loans often require stronger ICR figures

What Constitutes a Strong ICR?

Generally, Australian lenders consider the following ICR values when assessing commercial property loans:

Minimum Acceptable ICR

1. 1.5 - 1.7 (Higher risk)

Strong ICR

1. 1.8 - 2.0 (Preferred)
2. 2.0+ (Excellent)

Key Takeaways

Understanding ICR for Your Commercial Property Financing

1. ICR is a critical metric for determining your commercial loan borrowing capacity
2. Aiming for an ICR of 1.8 or higher will improve your loan approval chances
3. Different property types and locations may have varying ICR requirements
4. Working with a commercial loan specialist can help optimize your application to meet ICR requirements

For personalized advice on your commercial property financing needs, contact our team today.