A common question we are asked when talking to newer investors is: “What is the a debt service coverage ratio (DSCR) in real estate?” The DSCR is a number that is crucial for real estate investors to know on a property that they are interested in if they want to get a loan from institutional lenders. The main reason this ratio is so important is because it measures the potential profitability of the rental property.
What Exactly Does the DSCR Measure?
The DSCR is the ratio of a property’s Net Operating Income (NOI) to its debt payments (the principal and interest). On top of this, the ratio can be calculated using annual, quarterly, or monthly numbers.
NOI / Debt = DSCR
The higher this number, the easier it will be for the real estate investor to receive a loan. However, if this ratio is low, it will be much more difficult for the investor to get a loan on the property from lenders as the investment will be deemed “Higher Risk” by the banks.
In this video Landon explains what a Debt Service Coverage Ratio is and how it is calculated.
Why Does the Debt Service Coverage Ration Matter To Institutional Lenders?
Through the lens of the investor, profitability is one of the most important considerations when investing. Although a property that cash flows is helpful, long term appreciation, development and depreciation can also help improve the properties value. However, lenders aren’t looking through the same lens. To lenders, the DSCR represents the ability and timeliness of investors to pay back their loan, based upon the properties NOI and regardless of the investors personal financial situation.
Examples of DSCR and Real Estate Investing
For example, you, the reader, find a four-unit property right in the heart of East Nashville, and you want to mortgage it and rent it out. The current tenants pay $1200/mo each and the monthly mortgage payment is $2600. If you follow the formula, you will find that DSCR is about 1.85. This means that you could cover your debt almost twice, which is excellent news for you and the lender.
As another example, a triplex in Nashville (Davidson County, TN) is listed for 750,000 and you are ready to put $150,000 down on a 6.5% loan. Over 25 years your monthly payments would be approximately $4,050/mo. If the current tenants are paying $1,000/mo your DSCR would be $3,000(NOI)/$4,050(DEBT) or 0.74. In this scenario a bank would not likely lend to on this property unless you can show that the market supports significant rent increases, or you can bring more cash to the table reducing your total amount borrowed.
This video explains how you can impact your DSCR by raising your NOI or Decreasing your Debt.
Would you like Help with understanding DSCR in Real Estate?
With over 17 years of experience buying and selling multifamily properties RIA is the only real estate investment advisor you will need. We have helped broker over 600 deals for our clients, empowering them to make sound decisions. Call 615-560-7472 today or Schedule a Free Consultation to get started. Want to learn more about the DSCR, visit the Investopedia website.