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What Is Debt Service Coverage Ratio (DSCR)? & Its Importance

What Is Debt Service Coverage Ratio (DSCR)? And Its Importance

Amanda Byford
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Introduction Debt Service Coverage Ratio (DSCR)

When you are looking for a loan whether commercial or residential, there are many parameters based on which a lender will qualify you or your business or your investment property. 

One of the most important parameters in qualifying for a loan by the lender is the debt service coverage ratio. In this post, we will learn what DSCR is in detail and how it is calculated.

What Is Debt Service Coverage Ratio?

DSCR is a ratio that measures the cash flow available to pay the debt obligation on a commercial or investment property. 

It usually determines if the property in question can generate enough net operating income to cover the debt or loans including the principal and interest amount taken on the property. 

This ratio is based on the financing term selected by the owner. If there are two identical properties with different owners and one owner financed at 75% loan to value with one interest rate and the other at 50% loan to value with a different interest rate, the DSCR will be different for both the properties even if they are identical with the same sales price. 

Lenders across the country are looking for a DSCR of anywhere from 1.25% to 1.5%. However, it completely depends on the market. If the market is good the lenders may consider lower ratios as well.

How Is Debt Service Coverage Ratio Calculated?

Before we calculate the DSCR, we need to understand a few parameters that are required to know the DSCR for the property. 

The first thing that we would require is net operating income (NOI) which is the property’s or the company’s income after deducting operating expenses excluding taxes, interest payments, depreciation, and amortization each year.

The next thing we need to calculate the DSCR is the total debt service. This would include the interest and principal amounts that are paid by the investment or commercial property for all the short-term and long-term debt obligations. 

Getting the DSCR could be challenging when including income tax as the interest rate amount is tax-deductible and the principal amount is not. The best way to calculate the total debt service is:

Total Debt Service  = ( Interest x (1 – Tax Rate)) + Principal

The formula to Calculate Debt Service Coverage Ratio (DSCR) is:

DSCR = Net Operating Income (NOI) / Total Debt Service (TDS).

Let’s take an example here:

An investor is looking to purchase an investment property where the property has an NOI of $550,000 per year and the total debt service is $200,000 per year.

DSCR = 550000/300000 = 1.83

In this example, the DSCR for the property in question would be 1.83.

What Is The Significance Of Debt Service Coverage Ratio?

DSCR is commonly used to measure when negotiating credit agreements between companies and banks. For example, a company applying for a credit line may be required to ensure that its DSCR is not less than 1.25. 

If this happens, it can be determined that the property is not making enough cash flow to cover its current debt obligation. 

In addition to helping banks manage their risks, DSCRs also help analysts and investors analyze a company’s or the investment property’s financial strength.

What Is A Debt Service Coverage Loan or Investor Cash Flow Loan?

This is a type of loan provided by a lender specifically for purchase or refinance on an investment property with one to four units. 

The borrower qualifies for this loan based on the cash flow generated by the property itself per year rather than qualifying traditionally using personal income and debts. In a DSCR loan, the standard qualifying DSCR required is 1.25%. 

The best part DSCR loan is that the borrower does not need to submit any tax returns, pay stubs, or W2s. 

As long as the cash flow on the property is 1.25% or greater, the lender should be able to get your property qualified for a DSCR loan by providing the current lease agreement. 

Apart from the cash flow of the property, the owner should have one year of landlord experience. If this is your first time buying a rental property, you can hire a property management company to manage the rental property.

The lenders providing this type of loan would also want to take a look at the total number of investment properties owned by the borrower to analyze the total aggregate cash flow that the borrower gets from all his rental properties as part of reserves. 

In a DSCR loan, the minimum down payment required is 20% compared to a conventional investment mortgage where the minimum down payment is 25%.

Conclusion

When it comes to investment property financing, the debt service coverage ratio plays a significant part in qualifying for a DSCR loan. 

The lender would require having borrowers be above the threshold to qualify for this type of loan. 

The debt service coverage ratio also helps investors to analyze if the company or the investment property is making enough cash flow to pay the current debts so that it helps them decide whether or not to invest in the project.

Amanda Byford

Amanda Byford has bought and sold many houses in the past fifteen years and is actively managing an income property portfolio consisting of multi-family properties. During the buying and selling of these properties, she has gone through several different mortgage loan transactions. This experience and knowledge have helped her develop an avenue to guide consumers to their best available option by comparing lenders through the Compare Closing business.

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