Real estate investing is a lucrative strategy to make more money. Between residential and commercial properties, there are many opportunities for you to turn a profit and improve your financial outlook. Rental property investments are especially attractive.
Rental properties can be cash cows for property owners because they earn money from monthly rent. That means once all the expenses for each month are paid, such as maintenance fees, mortgage loans, insurance, and taxes, the rental income that remains is money in your pocket.
But getting started with rental property investing is the biggest obstacle to accessing this profitability. Many people don't have the income from their jobs to cover the costs of multiple mortgaged rental properties. Fortunately, there is a tool that lenders can provide to help you get a foot in the door. In this post, we're going to take a closer look at how Debt-Service Coverage Ratio works and how DSCR Loans help investors build large rental portfolios. We also have a DSCR calculator for you to use to help determine the profitably of your real estate investments.
What is a Debt Service Coverage Ratio (DSCR) Loan?
Most mortgage loans are dependent on a particular buyer's financial situation. For example, do they have enough income available to afford the monthly payment premiums that the loan will require?
A debt service coverage ratio loan works a little bit differently. Rather than qualifying for the loan based on your personal income and debt, the lender will use the property rent and income potential to determine if a borrower qualifies for the loan. After all expenses, such as taxes, insurance, and association dues, are paid each month, how much monthly rent must be generated to cover the cost of the loan? This ratio compares cash flow to operating expenses to help lenders gauge whether or not the borrower can pay back the loan. A DSCR calculator is a useful tool to help you determine if a property can bring in income. Let's take a closer look at how to calculate DSCR to better understand the DSCR calculator,
DSCR Formula and Calculation
To calculate DSCR for a particular property, there are several options. Real estate investors who want to get in on rental properties should understand how the debt service coverage ratio can be calculated so that they can do thorough research on specific properties that they are considering for their portfolio. Financial ratios are key to understanding the possibilities of a rental property.
Option 1: DSCR = Net Operating Income (NOI)/ Annual Debt Service
This method is most commonly used for commercial properties. To calculate DSCR with this method, you only need to know two numbers to come up with a decent estimate: the net operating income (NOI) and the annual debt service.
Net Operating Income
This number represents how much rental income is generated by the property after covering all other expenses. Expenses could include maintenance, utilities, insurance, taxes, property management fees, and other costs related to owning and running the property. Simply take your gross income and subtract all expenses to find the net operating income.
Annual Debt
This number is the total cost of your monthly debt obligations regarding principal and interest rate on an annual basis. Add your total principal and interest rates on the mortgage for the year together to find the annual debt service.
Now that you have these two numbers, simply divide the net operating income by the annual debt service. The result is your debt service coverage ratio. For example, if an investment property generates $100,000 of net operating income and has a total debt service of $70,000, its DSCR is equal to 1.43.
Option 2: (Monthly Rent - Maintenance - Property Management - Utilities) ÷ PITIA
The second way to calculate the debt service coverage ratio of an investment property is based more on monthly numbers. This usage of DSCR is more commonly used for residential rental properties. You take the total amount of monthly income, which is the rent coming in each month, and subtract costs like maintenance, property management, and utilities from that number.
PITIA
PITIA is an acronym that represents some of the costs related to owning the property and the loan itself. PITIA is the sum of the principal, interest, taxes, insurance, and association fees.
Now you take the top number and divide it by the total cost represented by PITIA and you have a good estimate of a monthly debt service coverage ratio. For example, a property that brings in $2,500 in rent each month and has a PITIA total of $2,250 has a DSCR of 1.11.
Uses of DSCR in Real Estate
There are multiple ways that DSCR is used in real estate investing to guide decision-making for both lenders and borrowers.
Can Cash Flow Support the Mortgage?
DSCR is very useful to help potential investors evaluate the profitability of a property. If the estimated cash flow of the property would easily cover the mortgage payments on top of all other expenses, then DSCR loans would be a very wise course of action.
Lender Analysis
Lenders want to make sure that the DSCR loans they give out are not too risky. If a borrower applies for a mortgage loan and the property, they want has a strong debt service coverage ratio, then the lender will see that the borrower's ability to pay back the mortgage is reliable. It will also help them set a fair interest rate on the loan and determine the maximum loan amount.
Determining the Down Payment
A DSCR is also useful for calculating what kind of down payment should be made on the property. If the ratio is barely above one, then a stronger down payment may be required to convince the lender to give out a DSCR loan.
What is a Good DSCR Ratio?
If you are asking this question purely from a mathematical standpoint, then any debt service coverage ratio above one is an optimal DSCR. This means that the cash flow from the property generates enough income to cover the debt payments, if only just. If the DSCR falls below one, then a greater down payment will be required or additional funds from another source will be needed to cover the cost of the loan.
What do A and B Lenders Require?
While there is some variation depending on which lender you are working with, most lenders at this level such as banks and private loan lenders will require a DSCR of at least 1.20 to consider giving out a DSCR loan. Lower ratios will likely mean you have to put more of your resources into the purchase price of the loan or have a higher interest rate.
What if the DSCR Ratio is 1.5 or Above?
DSCR works almost like a credit score. A credit score demonstrates one's ability to pay back their debts, so lenders like to see high credit scores. A DSCR greater than 1.5 indicates that a rental property can generate more than enough money to cover all payments and the total loan. The higher the DSCR is for a property, the better the interest rate you can obtain for the loan and the more cash flow you will bring in.
What Else Affects DSCR Loan Eligibility?
The Debt-Service Coverage ratio itself is not the only factor that matters for real estate investors looking for this type of loan.
Vacancy Rate
The rate of vacancy for a particular property directly impacts its gross operating income. Too many vacancies and the rental income will go down, making it harder to acquire a loan based on DSCR. As the borrower, you should make sure that the property you are interested in has few vacancies.
Personal Income/Assets
Many lenders know that even a property with strong vacancy rates could suddenly see a minor decline in tenants, bringing the DSCR below one. Lenders will protect themselves from defaults in that scenario by ensuring that the borrower has some income or capital of their own to cover the mortgage payments. They may study your pay stubs, bank accounts, and tax returns to understand your status.
Use a DSCR Calculator Today
Want to evaluate the financial strength of a property you are interested in? The ability to quickly calculate DSCR will help you during the research phase as you seek to grow your real estate portfolio.
A DSCR loan calculator can also help you determine what kind of rent you need to generate to keep up with payments and continue turning a profit. Use this free tool to fulfill your DSCR calculation needs and play with numbers like operating costs, the principal, the interest rate, the down payment, and more.
