The debt service coverage ratio (DSCR) is a ratio that measures the rental income or cash flow of an investment property vs the annual payments toward debts. This ratio is a critical metric used by real estate investors borrowing a debt service coverage ratio mortgage. Based on the ratio, potential borrowers may be approved or denied for a DSCR mortgage.
If you’re a short-term or long-term rental investor seeking a debt service coverage ratio (DSCR) loan, consult the premier mortgage brokers of The Mortgage Shop. With this debt service coverage loan, you can avoid the typical income verification requirements of conventional loans. You will also save time with the commercial loan underwriting and approval process.
The following article will cover everything a real estate investor needs to know about the debt service coverage ratio and how it is used to finance a rental property.
Understanding the Debt Service Coverage Ratio (DSCR) in Real Estate
What is DSCR in Real Estate?
The debt service coverage ratio (DSCR) metric applies to borrowers taking out a DSCR mortgage. This measure determines the investor’s capacity for repaying annual debt on the loan. The DSCR does this by comparing the borrower’s net operating income (NOI) from the rental property to the borrower’s outstanding debts.
Collectively, these annual debt payments are called the annual debt service or total debt service. By using the debt service coverage ratio, a lender decides if the potential borrower generates enough income from the rental property to cover the mortgage and debt obligations.
Whether the property is an owner-managed property or managed by a landlord, if it cannot generate enough cash flow to cover outstanding debt, the lender may deny the owner a DSCR loan altogether.
A higher debt service coverage ratio (DSCR) ratio indicates that the investor has more net operating income (NOI) to pay off or service debt.
Using the Formula for Debt Service Coverage Ratio (DSCR)
The debt service coverage ratio formula is a calculation that takes into account net operating income and various debt service factors. It is the formula lenders use to calculate your ability to pay back the commercial real estate loan.
This DSCR meaning is based on a specific debt service ratio equation. To calculate DSCR, use this equation for debt service coverage ratio:
Annual Net Operating Income (NOI) / Annual Debt Service = DSCR
If your property generates an annual NOI of $10,000 and your annual debt service is $7,500 (including annual principal and interest payments), the debt service coverage ratio (DSCR) calculation gives you 1.33, or 33% above breaking even.
In other words, you have enough income and positive cash flow from your rental property to cover your debt service. This extra money is essentially savings.
When calculating DSCR, it’s important to factor in all annual debt payments and expenses that are relevant. If your final DSCR value is 1.0 or less, you may struggle to get approved for a debt service coverage ratio mortgage. Many lenders will look for a ratio of at least 1.25, meaning you have 25% ‘wiggle room’ after your debts are paid.
You may be able to obtain financing with a lower DSCR ratio, but you will be required to make a larger down payment to do so.
How to Calculate Your NOI in the Debt Service Coverage Ratio (DSCR) Equation
All rental properties have net operating income, which is the annual net income in addition to amortization, depreciation, interest, and related non-cash considerations. Your NOI is important because it affects your debt service coverage ratio as well as how much you can afford to service debt. Your mortgage loan amount is also impacted by your annual net operating income.
Your annual net operating income (NOI) is determined by subtracting operating expenses from your property income.
You can determine your property’s income by subtracting the rate of vacancies and relevant expenses for credit from the property’s total income sources.
This is called your gross operating income and is a metric used to eventually calculate your net operating income.
Calculating Gross Operating Income in Your Debt Service Coverage Ratio
As a property investor concerned with sufficient cash flow, loan payments, and debt service obligations, you must understand your various income figures. If you don’t, you may struggle with real estate finance and have insufficient funds to own a rental property.
The gross operating income figure can be calculated as follows:
Rental Income Maximum – Rate of Vacancies = Gross Operating Income
Remember, your maximum rental income is more than merely monthly rent. You may also collect money from utilities, pet charges, garage and parking fees, appliance rents, and more.
This rental income maximum refers to the income an investor would receive if the property had a 0% vacancy rate. Talk with your property manager or a professional management team to figure out the vacancy percentage.
Many multifamily properties average vacancies of between 5% and 10%.
Once you know this vacancy rate and your potential rental income, you can calculate your gross operating income. With this determined, it’s time to figure out each ongoing operational expense.
Calculating Operating Expenses in Your Debt Service Coverage Ratio (DSCR)
Your operating expenses for your property can include many fees and costs you might not have considered. Be sure to carefully calculate these operating expenses for the property.
Still wondering, what is DSCR in real estate?
Before you can answer that, you should add up the following:
- Maintenance and repairs
- Property insurance
- The property management fee
- The HOA fee
- Utilities (i.e., multifamily property)
- Property taxes
Do not include current or future capital expenditures, depreciation deductions, or any debt service/mortgage payment.
Annual Gross Operating Income – Annual Operational Expenditures = Annual Net Operating Income
Now that you have the necessary operating expenses, you can subtract that from your gross operating income. This will give you your net operating income. Your net operating income divided by your total debt service is your debt service coverage ratio.
This number indicates if you have enough operating income to cover your debt service, including your property’s required expenses, loan payments, and other annual debt payments.
Lenders will also assess your debt yield. Debt yield is your net operating income divided by the total loan amount.
The higher the percentage, the more likely real estate investors are to get approved. A 10% debt yield is typically the minimum debt yield allowed. You should always aim for a debt yield above this as your lender will feel more confident in lending to you.
Getting the Debt Service Coverage Ratio (DSCR) Loan Right for You
Any mortgage based on DSCR calculation can vary. Depending on your cash flow, debt service coverage, loan risk, and your company’s ability to cover the debt service, your debt service coverage ratio product may vary significantly. After all, significant lender adjustments can and do occur.
The maximum supportable loan amount usually ranges from $1 million to $2 million with varying terms and restrictions. Think of debt service coverage ratio loans as business loans for your investment business.
Confused or unsure about this commercial lending option? Worried about underwriting commercial real estate? Want to see how loan payments compare? Whether you need a fixed interest rate on your commercial property loan, are just starting to consider a new loan, or want the maximum loan possible, you deserve the best brokers around.
A top lender makes adjustments based not only on your debt service coverage ratio but your financial and investment goals too.
If you’re still wondering what DSCR is in real estate, have questions about borrowing, or want to explore premier loan options immediately, meet The Mortgage Shop team of DSCR experts today.