There are two main ways to finance an investment property. You can get a loan based on your personal income and assets or one based on the property's income potential.
If you choose the latter, you'll go to an asset-based lender that looks at the property's debt service coverage ratio, or DSCR.
Here's what real estate investors should know about the debt service coverage ratio.
What is the debt service coverage ratio?
The broad definition of debt service coverage ratio, or DSCR, is a business's net operating income (NOI) divided by its total debt service obligations. If you own a small business that generates an NOI of $200,000 this year and you pay $100,000 to service your business debts, you have a DSCR of 2 ($200,000 / $100,000).
The definition of an acceptable DSCR varies depending on who you ask, but here are some guidelines:
- A DSCR above 1.0 means the business generates enough cash flow to cover its debt obligations.
- A DSCR below 1.0 means the business doesn't generate enough cash flow to cover its debt obligations. (Though an investor may be able to cover the debt with other sources of income.)
- A DSCR significantly above 1.0 means there's enough of a cushion to keep debts paid even if profits fall.
Why DSCR is important to real estate investors
When it comes to financing income investment properties, two general types of loans are available. You can get a conventional mortgage based on your income, credit, and assets -- or you can get a loan from an asset-based lender that's mainly concerned with how much income the property will generate.
Asset-based lenders use the debt service coverage ratio to determine whether a property justifies a certain loan amount. With an acceptable DSCR, an investor can get a mortgage on a rental property regardless of their personal debt-to-income ratio or employment history.
There are no set-in-stone DSCR guidelines; lenders have different preferences. Here are a couple of general rules of thumb:
- Asset-based real estate lenders typically want to see a DSCR well above 1.0. A DSCR of exactly 1.0 means the property makes just enough money to cover its debt obligations but not enough to cover property management fees, maintenance costs, and other expenses. Most lenders want to see a DSCR of at least 1.2.
- Many lenders have different tiers of DSCRs and higher values can make it easier to get approved for a loan with a lower interest rate. For example, a lender may approve loans with a DSCR of 1.2 but give preferential interest rates to DSCRs greater than 1.35.
Besides financing applications, DSCR can be a great tool for comparing prospective investment properties.
Calculating the debt service coverage ratio for real estate
Asset-based lenders typically calculate the debt service coverage ratio by taking the property's monthly rent (or expected monthly rent if it's unoccupied) and dividing it by the monthly debt payment. This includes principal, interest, taxes, insurance, and any association dues (PITIA).
For example, let's say you're looking into an investment property with an expected rent of $1,200 per month. Your monthly debt service payment includes the following:
|Principal + interest||$600|
In this case, the DSCR is $1,200 / $900, or 1.33.
The bottom line on DSCR
Debt service coverage ratio is an important metric for real estate investors to know -- not only for financing, but also for your own cash flow calculations when comparing prospective investment properties.
By knowing your DSCR, you'll be better equipped to pursue the right kind of financing and make smart decisions when it comes to buying rental properties for your portfolio.