DEBT SERVICE COVERAGE RATIO (DSCR)
The most 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
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.
Net operating income is the income from a rental property left over after paying all of
the operating expenses:
Gross Scheduled Rents $100,000
Less 5% Vacancy & Collection Loss $5,000
________
Efective Gross Income: $95,000
Less Operating Expenses
Real Estate Taxes
Insurance
Repairs & Maintenance
Utilities
Management
Reserves for Replacement
Total Operating Expenses: $30,000
Net Operating Income (NOI) $65,000
Please note that lenders always insist on some sort of vacancy factor regardless of the
actual vacancy rate in an area to cover collection loss. In addition lenders always insist
on using a management factor of 3-6% of effective gross income,
even if the property is owner-managed. Their logic is that they would have to pay for
management if they took back the property. 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 poperty, not just the first mortgage. NOTE THAT WE
HAVE NOT INCLUDED TAXES AND INSURANCE. They were already accounted for above when we
arrived at net operating income (NOI).
To calculate the debt service coverage ratio, 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
11% Interest, 30 years amortized
Annual Payment (Debt Service) = $57,139
Then:
DSCR = Net Operating Income (NOI) = $65,000
Total Debt Service $57,139
DSCR = 1.14
Obviously the higher the DSCR, the more net operating income is available to service the
debt. From a lender's viewpoint it should be clear that they want as high a DSCR as
possible.
The borrower, on the other hand, wants as large a loan as possible. The larger the loan,
the higher the debt service (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 are very conservative and generally require a 1.25 or 1.35 DSCR.
This means that their loan-to-value ratios are low. Savings and loans (S&L's)
generally only require a 1.20 DSCR, and sometimes will accept a DSCR as low as 1.10.
A DSCR of 1.0 is called a breakeven cash flow. That is because the net operating income
(NOI) is just enough to cover the mortgage payments (debt service).
A DSCR of less than 1.0 would be a situation where there would actually be a negative cash
flow. A DSCR of say .95 would 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 keep the project afloat.
Generally lenders frown on a negative cash flow. Some lenders will allow a negative cash
flow if the loan-to-value ratio is less than around 65%, the borrower has strong outside
income such as an electronic engineer, and the size of the negative is small. Lenders
rarely allow negative cash flows on loans over $200,000. |
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