The Debt Service Coverage Ratio, or DSCR, is often overlooked by investors, but arguably the most critical metric when analyzing real estate investment opportunities. DSCR loans typically do not require borrowers to qualify on their income but rather on the rent forecasts on the subject property. It is a way to buy an investment property based on the merit of the dwelling or commercial property rather than the buyer.
What is DSCR?
DSCR is the ratio of Net Operating Income (NOI) to Debt Service (in the case of residential real estate, this is the mortgage payments).
(Typically expressed as a number followed by ‘x’)
Finding the NOI for a property consists of taking the gross income and subtracting operating expenses, such as property improvements, tenant contracts, and other property management costs. Lenders will often include a management fee in their NOI calculation, even if the owner (or borrower) plans to manage the property themselves. This adjustment will result in a lower NOI, ultimately bringing the DSCR down. Accounting for these types of adjustments helps lenders to hedge their risk in the loan.
In the case of residential real estate properties, the debt service is the mortgage payments (principal, interest, taxes, and insurance). The DSCR is expressed as a ratio. If the NOI is less than the debt service, the resulting number will be less than one. This number means that the NOI is not enough to cover the debt service on the loan. Lenders typically look for DSCR of 1.2-1.4x, meaning that NOI is 20-40% higher than the debt service payments. This percentage provides a cushion that results in mitigated risk for the lender.
Gross Yield (revenue) = $20,000
Operating Expenses (maintenance, improvements, etc.) = $5,000
=>Net Operating Income = $15,000
Debt Service = $12,000
NOI/Debt Service = $15,000/$12,000
DSCR => 1.25
If the DSCR on a property is 1.0x, that would mean that the cash flow from NOI is equal to the debt service. Therefore, lenders would not look at this as a safe investment. When this occurs, the lender will want a larger down payment or may increase their interest rate as a way to mitigate risk. If anything were to go wrong, then the debt service would still need to be repaid-in this case from the Owner’s pocket. Lenders want a safe risk. They want owners to make smart, safe investments.
Bad DSCR: Negative Cash Flow
If the DSCR is calculated to be less than 1.0x, this means that there is not enough cash flow to cover the debt service. The uncovered debt service would have to be repaid out of the owner’s pocket. For example, if the mortgage of a property is $1,000 and the NOI is $950, the remaining $50 would have to be paid by the owner. This ratio of .95x is not favorable for the lender or the borrower. Our investors will allow DSCR down to .5x but in these negative cash flow situations, underwriters will look for additional positive factors like additional assets in the bank and larger down payments.
What DSCR Means For Borrowers
DSCR is an essential tool for lenders. Therefore, it should also be incredibly crucial for borrowers, as well. Calculating the DSCR for an investment property will help the borrower understand their risk and what cash flow they can expect. It is necessary to realize that various lenders will calculate this ratio in slightly different ways. Some lenders may include reserves for future capital expenditures in their DSCR calculation, and some may not. Ultimately, the adjustments that lenders make to DSCR help them understand their risk in the transaction.
DSCR is a safety metric for lenders and borrowers alike. It should be one of your primary tools as you assess investment properties. Curious about other tools for deciding if a deal has good potential? Check out this informational post on what the 70% rule is and how to use it. If you are interested in making a property investment, contact Park Place Finance today, and we can help you get started.