Debt Service Coverage Ratio (DSCR)
The important ratio to understand when making income property loans is the debt service coverage ratio. It is defined as: DSCR = Net Operating Income (NOI) / Total Debt Service. Email Debt Service Coverage Ratio questions.
To understand the ratio, it is first necessary to understand the numerator and the denominator. Let's take a look at net operating income (NOI) first. NOI is the income from a rental property left over after paying all of the operating expenses:
Gross Scheduled Rents $100,000
Less Vacancy & Collection Loss (5%) $5,000
Effective Gross Income: $95,000
Less Operating Expenses:
Real Estate Taxes
Repairs & Maintenance
Reserves for Replacement
Total Operating Expenses: $35,000
Net Operating Income (NOI) $60,000
Please note that lenders always insist on some percentage as a vacancy factor, regardless of the actual vacancy rate in an area to cover collection loss. In addition, lenders always include a management expense of 3-6% of the effective gross income, even if the property is owner-managed. Their logic is that the owner earns that fee, which they would have to pay to others, if they took back the property in a default situation.
Finally, NOTE THAT WE HAVE NOT INCLUDED LOAN PAYMENTS AS AN OPERATING EXPENSE.
Next let's look at the denominator, Total Debt Service. This includes the principal and interest payments of all loans on the property, not just the first mortgage. NOTE THAT WE HAVE NOT INCLUDED TAXES AND INSURANCE. They were already accounted for above, in the Operating Expenses, when we arrived at the net operating income (NOI).
To calculate the debt service coverage ratio (DSCR), simply divide the net operating income (NOI) by the mortgage payment(s). For the sake of simplicity, let us assume that there is only one mortgage on the property:
$500,000 First Mortgage
7.5% Interest, 25 year amortization
Annual Payment (Debt Service) = $44,340
Debt Service Coverage Ratio = Net Operating Income (NOI) = $60,000
Total Debt Service $44,340
DSCR = 1.36
Obviously the higher the Debt Service Coverage Ratio, the more net operating income is available to service the (new loan) debt. From a lender's viewpoint it should be clear that they want as high a Debt Service Coverage Ratio as possible.
The borrower, on the other hand, wants as large a loan as possible. The larger the loan, the higher the debt service (the mortgage payments). If the net operating income stays the same, and the loan size and therefore the debt service increases, then the lower the DSCR will be.
Life Insurance Companies, as lenders, are very conservative and generally require a minimum 1.25 or 1.35 DSCR. This means that their loan-to-value ratios are low. Many other types of lenders may consider a lower DSCR (depending on the type of property) and sometimes will accept a DSCR as low as 1.10. A DSCR of 1.0 is called a break-even cash flow. That is because the net operating income (NOI) is just enough to cover the mortgage payments (debt service).
A Debt Service Coverage Ratio of less than 1.0 would be a loan where there would actually be a negative cash flow. A DSCR of say .95would mean that there is only enough net operating income (NOI) to cover 95% of the mortgage payment. This would mean that the borrower would have to come up with cash out of his personal budget every month to meet operating expenses and mortgage payments. Generally lenders frown on negative cash flow. Some lenders may allow a negative cash flow if the loan-to-value ratio is low, the borrower has stable and strong outside income, with great personal liquidity, and the size of the negative cash flow is manageable, which will be rectified in the foreseeable future.
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