When you invest in real estate, the debt-service coverage ratio (DSCR) is one of the many metrics you can use to determine if your property is profitable. This ratio tells you if you’re earning the amount of income you need to cover your debt obligations. Lenders often use this calculation to identify if a potential borrower is making enough money to refinance their property.
DSCR is an important component in any financial analysis. If you’re not bringing in enough rental income to pay for your debt obligations, you may need to increase rent prices or find ways to reduce your debt.
With the DSCR, you can analyze the health of your investment early on, which will give you the data you need to make smart and informed decisions. The purpose of this article is to help you understand the debt coverage ratio and how you can use it to analyze any real estate investment.
The debt-service coverage ratio is a calculation that’s often used by real estate lenders and investors alike. The purpose of this metric is to determine if the operating cash flow of a rental property is high enough to support all debts associated with it. Lenders use this calculation to make sure that an investor who’s applying for a refinance loan is earning enough income to qualify. To calculate the DSCR metric, use the following formula:
Net Operating Income (NOI) / Total Debt Service (TDS)
Your property’s TDS involves all the expenses you need to pay to avoid foreclosure. These expenses include everything from taxes and insurance to the principal and interest of the loan. Depending on where the property is located, your expenses can include HOA fees. As for your net operating income, it involves the monthly rent you collect minus any vacancy and operating expenses.
The DSCR reflects your ability to repay the debt you owe with the income you earn. Companies also use this calculation to determine if their cash flow is healthy enough to regularly pay their debts. If you attempt to refinance a property or purchase another rental investment, your lender will likely measure the DSCR of your existing property.
When a bank or other financial institution looks at a borrower’s DSCR, the purpose is to ensure that they aren’t taking on too much risk by approving a loan. If your DSCR is high enough, your lender can be confident that you’re maintaining financial stability with your current investment. With a low DSCR, you may find it challenging to gain loan approval from your lender.
If you’re looking to purchase a rental property from another investor, make sure you use the DSCR calculation to determine if the property’s cash flow is high enough. If the ratio is lower than you’d like it to be, consider other properties. Keep in mind that your lender will also use this metric to see if you qualify for a loan.
The formula for the debt-service coverage ratio is straightforward. Once you identify your net operating income and your total debt service, divide the first number by the second. Let’s say that your net operating income is around $10,500 and your annual mortgage payment is $8,900. To identify your rental property’s DSCR, divide $10,500 by $8,900, which gives you 1.18.
With a DSCR of 1.18, you’ll have more than you need to pay your annual debts. If the ratio is less than 1.0, you likely won’t be able to afford all your debt payments unless you use some of your own income to pay for them. Before you do this calculation, let’s take a look at how to determine NOI.
Your property’s net operating income is a crucial component of the DSCR calculation, which is why the number you obtain must be accurate. If you apply for a loan and use an NOI that’s higher than you actually earn, you may eventually have difficulty repaying the loan. To perform this calculation, deduct all operating expenses from the gross income your property generates. Use the following formula to obtain your property’s gross operating income:
Rental Income – Vacancy Rates = Gross Operating Income
If you rent out a single-family home, the money you receive comes from the rent that a tenant pays every month. You might also earn some extra income from utilities, appliance rent, or pet rent.
If you’re using the DSCR calculation before you buy a rental property, you can do so by identifying your potential rental income. Your potential income is based on an assumption that the property will be constantly occupied during the year, which is rarely the case. You’ll need to deal with periods when your rental property is vacant. Some investors will add an estimated vacancy rate reduction of 5%-10% to their rental income.
Once you identify your gross operating income, you’ll need to add up the operating expenses that you pay every month. The most common operating expenses associated with single-family rentals are:
Once you subtract your operating expenses from your gross income, you’ll know what your property’s net operating income is. Let’s say that a rental property produces an income of $13,000 every year. If the operating expenses amount to $6,000, the NOI will be $7,000.
If you need help with your DSCR calculations, there are many online tools available to you. Most of these tools are free to use. Consider online DSCR calculators from OfferMarket and FundLoans.
If you’re wondering what the ideal DSCR is, it depends on several factors. The best DSCR for a lender might differ from what an investor prefers. Keep in mind that the DSCR of your rental property can change if your NOI increases or decreases. If you’re buying your first rental, a DSCR of 1.0 may be sufficient until you can find ways to reduce your operating expenses. Lenders usually require a DSCR of 1.25 or higher. The ideal DSCR for a lender is around 2.0.
If you have a DSCR that’s less than 1.0, your property isn’t producing enough income to cover the principal of the loan and any interest payments that are tied to it. A DSCR that’s equal to 1.0 indicates that you’ll have enough cash flow to cover your debt payments. However, there won’t be anything left over. While this isn’t a low DSCR, your lender may not approve a loan unless you increase this ratio. If you have a high DSCR, you’ll be able to more comfortably cover your debt payments, which also increases the likelihood that you can obtain a loan.
In real estate investments, DSCR is commonly used to estimate how profitable a property might be. Unless you’re paying for the property with cash alone, you’ll need to seek a loan from your preferred lender. Let’s assume that you’re considering buying a rental with a $200,000 asking price. If your lender requires a DSCR of 1.30, you can determine if your loan will be approved by identifying how much net operating income the property is currently generating.
You can improve the DSCR by increasing your down payment. In this scenario, the principal and interest of your loan will effectively drop. If you discover your lender’s preferred DSCR as well as the amount of capital you’re willing to provide as a down payment, you’ll know what the ideal price is when searching for a rental property.
There are numerous strategies you can use to increase your net operating income, which will improve your DSCR. Consider the following techniques:
You can also improve your DSCR by reducing your total debt service. If you have yet to buy a rental property, the simplest way to lower your TDS is by making a larger down payment. Utilize long-term financial planning to effectively reduce your expenses and maintain high cash flow. For example, most rental properties come with numerous tax breaks. Take advantage of the exemptions and deductions at your disposal to increase your income.
While the DSCR calculation can be helpful before and after you purchase an investment property, it’s not perfect. For example, DSCR results can be misinterpreted. A property’s NOI can change considerably in a short period, which is why it’s important not to over-rely on this metric to make financial decisions.
The most common mistake that investors make when performing this calculation involves using the property’s gross rental income instead of its NOI. Make sure you subtract your operating expenses from your total income before you measure your property’s DSCR.
The DSCR is a highly effective calculation that allows you to determine if a property will be profitable. You can use this metric before buying an investment property by estimating your potential rental income. To perform the DSCR calculation, identify a property’s net operating income. You must then divide this number by the property’s total debt service, which includes the loan’s principal and interest. Regularly monitor your rental property’s DSCR to ensure you can still meet your debt obligations. Seek professional financial advice to avoid making poor investment decisions with the DSCR.
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