Debt service coverage ratio (DSCR) is a ratio that compares a company or individual’s total debt obligations to its income. Lenders use it as a metric to determine a borrower’s financial health. For a company, it can be the determining factor on a business loan. For an individual, it can be the determining factor on a car, home, or small business loan.
But how does it apply to real estate investing?
Let’s take a closer look at DSCR and how lenders and investors in real estate use it.
Key takeaways:
- The debt service coverage ratio in real estate indicates a property’s financial health.
- Most real estate investors consider a good debt service coverage ratio to be at least 1.25.
- DSCR changes over time.
- Real estate investors and lenders use DSCR to analyze a property’s performance.
What is the debt service coverage ratio?
In real estate, the debt service coverage ratio is a metric that helps analyze an investment property’s performance.
DSCR measures the borrower’s (investor’s) ability to repay the annual debt service compared to the amount of net operating income (NOI) a property generates. It’s an indicator of whether or not a property generates enough income to cover the mortgage payments.
When a real estate investor applies for a new loan or refinance, lenders use DSCR to determine the maximum loan amount.
What’s a good DSCR?
There is no standard for a good DSCR because it varies by situation and lender. However, there are some general guidelines real estate investors can follow.
A DSCR below 1 means the property doesn’t generate enough income to cover its debts. A DSCR of 1 means that 100% of the property’s NOI goes toward paying its debts. A DSCR above 1 indicates the property has a higher NOI than is needed to pay annual debts.
For most real estate investors, a good debt service coverage ratio is at least 1.25.
How to calculate DSCR
Calculating the debt service coverage ratio is pretty simple. In real estate, it’s calculated by dividing a property’s annual net operating income (NOI) by its total debt service. NOI is essentially all of the cash flow the property generates.
Here’s the debt service coverage ratio formula.
DSCR = NOI / Debt Service (principal and interest payments)
Here’s an example of how to use it.
Let’s say a real estate investor wants to refinance a rental property to take advantage of lower interest rates. The property has an annual NOI of $7,000, and the annual mortgage payment is $5,000 (including principal and interest). They want to perform a DSCR calculation before they go to the lender. So, they plug the numbers above into the DSCR formula.
DSCR = NOI / Debt Service
1.6 = 8,000 / 5,000
In this example, this rental property has a DSCR of 1.6. This means there is extra net operating income than is needed to service the annual debt.
How to calculate NOI
Net operating income (NOI) is essential to calculating the debt service coverage ratio, the mortgage loan amount a real estate investor can get, and the amount of income they have available for debt repayment. It’s essential to know how to calculate NOI correctly.
And here’s why.
A net operating income that’s miscalculated too high can lead to an investor who is unable to repay their debts. An NOI miscalculated too low can prevent an investor from getting loans for more properties.
NOI is calculated by adding up all income a property generates and subtracting all operating expenses.
Here’s the net operating income formula.
NOI = Gross Operating Income / Gross Operating Expenses
The first step in calculating NOI is to calculate gross operating income.
Here’s how to calculate a property’s gross operating income.
Gross Operating Income = Potential Rental Income – Vacancy Rate
Potential rental income includes the monthly rent a tenant pays plus any extra income from the property. This may include pet rent, utilities, or storage unit fees.
The second step in calculating NOI is calculating the property’s vacancy rate. It’s unrealistic to assume a rental property will always be occupied. That’s why some real estate investors use a 5-10% vacancy rate, but it’s not always reflective of the market. The best way is to review the property’s records and talk with a local real estate agent to understand vacancy rates in the local market.
Here’s an example of how to calculate gross operating income.
Let’s say a real estate investor has a rental property with a potential rental income of $5,500 per year. They reviewed the property’s records and consulted a real estate agent to determine a vacancy rate of 10%.
Gross Operating Income = Potential Rental Income – Vacancy Rate
4,950 = 5,500 – 550
The property has a gross operating income of $4,950 per year.
Now it’s time to calculate the property’s annual operating expenses. These typically include property management fees, maintenance, property taxes, insurance, utilities, and HOA fees. They do not include necessary expenses like capital expenditures (CapEx), mortgage payments, depreciation, and debt service.
Once an investor has determined their gross operating income and operating expenses, they can determine their net operating income.
Let’s use the example above, where the investor’s property has a gross operating income of $4,950 per year. The property’s operating expenses are $2,000.
NOI = Gross Operating Income – Operating Expenses
2,950 = 4,950 – 2,000
In this example, this property has an NOI of $2,950.
How DSCR is used in real estate investing
Investors and lenders use the debt service coverage ratio in the real estate investing process.
Let’s say a real estate investor wants to purchase a rental property that’s listed for $175,000.
Before they make their offer, the investor talks with their lender and learns the lender requires a minimum DSCR of 1.25.
The investor talks to the property owner and anticipates a net income of $8,5000. They use this information and minimum DSCR to calculate the annual debt service the lender will allow and the down payment needed.
Here’s how.
They rearrange the DSCR formula to calculate the maximum allowable mortgage payment.
Debt Service = NOI / DSCR
6,800 = 8,500 / 1.25
The investor meets with the lender and learns they’ll need to put a minimum 20% down payment on the property to qualify for the loan. The investor can then determine if this is the right property for them or use the information to shop around in different real estate markets.
Does DSCR change over time?
Yes. The debt service coverage ratio of an investment property will change over time. This is due to several factors like fluctuating net operating income.
Here’s an example.
The above table assumes the investor took out a mortgage with traditional terms and amortization where the principal and interest payments remain the same. There can be even greater fluctuations in DSCR if the debt service changes over time due to different loan terms that result in changes in loan payments.
The bottom line
DSCR is commonly used in finance to determine a company or individual’s financial health. In real estate, it’s used to determine a property’s financial health because it relies on the property’s NOI versus the investor’s income. A good DSCR is 1.25 or higher because it indicates the property’s net operating income can cover its debt service plus 25%. Use DSCR as a guide when determining whether or not an investment property is right for you.
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