Real estate investors rely on flexible financing that is designed for their unique scenarios.
One popular option for financing properties is the debt service coverage ratio (DSCR) loan, which focuses on the property’s cash flow through rental income rather than the borrower’s personal finances.
Construction projects have different financial needs. They typically are unable to generate income until they are completed and either leased or sold.
Investors well-versed in DSCR loans may wonder if they can be leveraged to finance a construction project.
In this article, we’ll discuss whether DSCR loans can be used for construction, alternative financing options, and strategies for combining financing strategies to meet your investment goals.
Start your application with Park Place FinanceWhat is a DSCR loan? How does it work?
DSCR loans focus on the income-generating potential of a property rather than the investor’s income and financial history.
By calculating a property’s DSCR, investors and lenders can determine whether the property will generate enough income to cover its debt obligations.
How to calculate a property’s DSCR
The formula is:
DSCR = Net Operating Income (NOI) / Total Debt Service
NOI is the income generated by the property minus operating expenses like property taxes, insurance, and management fees.
Total debt service is the total loan payment, including principal and interest.
What’s a ‘good’ DSCR?
A DSCR above 1.0 means the property produces more income than needed to cover its debt obligations, while a DSCR below 1.0 suggests that the property may not be able to meet its debt obligations.
How do investors use DSCR loans?
DSCR loans are most often used by investors with income-generating properties.
Common uses include:
- Purchasing rental properties
- Refinancing income-producing properties
- Expanding investment portfolios
- Post-renovation or post-construction financing (if the property begins generating income)
DSCR loans are a flexible, scalable alternative to traditional financing, making them a go-to solution for real estate investors.
Can DSCR loans be used for construction?
While DSCR loans can be used in a wide range of investor scenarios, they aren’t particularly well-suited for construction projects.
Here’s why:
- No existing NOI: During construction, the property isn’t generating rental income, and it would be difficult for lenders to predict the rental income for a project that isn’t near completion.
- Potential risk for lenders: Construction projects are riskier due to the potential for delays, cost overruns, or market fluctuations. DSCR loans focus on stable, income-producing properties.
Accurate income predictions rely on completed construction projects and successful leasing or sales.
In later phases of construction, and particularly those that are near completion, your lender may be able to get a better idea of the income potential.
Scenarios where DSCR loans may work with construction
Is there any world where you can use a DSCR loan for a construction project?
Here are some situations where this type of loan may apply:
- Pre-leased properties: If a portion of the property is pre-leased before construction is complete
- Phased construction projects: If completed portions of the project are generating income while other phases are still under construction
Discuss your investment vision with a trusted hard money lender like Park Place Finance. Our team can help you determine which financing options are right for you.
Alternative financing options for construction or extensive renovation projects
Fortunately, real estate investors have several alternative financing options for construction projects.
Construction loans: Tailored for ground-up projects and building costs
Construction loans cover the costs of building new properties from the ground up, including land, materials, and labor.
These loans are typically short-term and provide funding until the property is completed. Funding is typically disbursed in draws that align with certain project milestones.
DSCR loan comparison: Construction loans are best suited for the active building phase, while DSCR loans can be used after the property is completed and begins generating rental income.
Fix-and-flip loans: For short-term projects to renovate and sell properties quickly
Fix-and-flip loans are for investors who want to purchase, renovate, and sell properties for a profit.
They provide the upfront capital needed to purchase the property and improve it within a short timeframe. The properties typically need significant upgrades.
DSCR loan comparison: While generating rental income typically isn’t the goal for fix-and-flip investments, some investors do choose to fix and hold a property.
In this case, they may use a fix-and-flip loan to purchase and improve the property, then refinance to a DSCR loan to hold the property long-term and generate rental income.
Bridge loans: Temporary financing for transition phases
Bridge loans “bridge the gap” between an immediate need for financing and a more permanent financing solution.
They provide rapid approval and funding for a short timeframe and can be used for various purposes, including purchasing land, a property, or even pre-construction costs until a more specific or permanent source of financing is acquired.
DSCR loan comparison: Bridge loans bridge financing gaps, while DSCR loans are a long-term financing option for income-generating properties.
Investors may use a bridge loan to quickly secure a rental property, then refinance to a DSCR loan.
Strategies for combining financing tools
While a construction loan, bridge loan, or fix-and-flip loan may suit your initial construction or renovation needs, investors often use more than one type of financing.
These three loan types have one thing in common: They are all short-term financing solutions.
Once the property is purchased or the construction or renovation is completed, the investor will need a permanent source of financing.
If the goal of the property is to generate rental income, a DSCR loan may be a perfect solution.
Find the right financing solutions for your investments
The first step in choosing the right financing option is to define your project goals and determine whether your project may require more than one type of loan.
You don’t have to do it alone—a trusted hard money lender like Park Place Finance can show you all your loan options and help you find a solution tailored to your project.
Park Place Finance has funded over $1 billion in loans across 47 states and 17 years in business. We have the experience and expertise you need to reach your investment goals.
Ready to find the perfect financing option(s)? Submit your loan needs on our website or call (866) 407-1599.