The phrase “debt-service coverage ratio” (or DSCR) is about as clear as mud, but it’s really just fancy lender speak for “does the monthly rent for the property generate enough cash flow to pay the monthly mortgage payment, property tax, and property insurance?” Let’s take a closer look at this calculation for both commercial and residential properties, what makes a good DSCR, and why it matters to lenders and investors.
What is DSCR?
From a lender's point of view, DSCR is a tool to help understand a borrower's ability to pay back a loan based on the monthly rent of the property. Essentially, it is a simplified way to measure cash flow and is calculated by dividing the monthly rent by the monthly principal, interest, taxes, insurance, and association dues (PITIA). Unlike a net operating income — or NOI — calculation, DSCR does not specifically take into account other common items such as vacancy rates, advertising costs, and maintenance reserves.
What is a good DSCR ratio?
While it varies between lenders, typically anything above a 1.2 is considered good, and anything above a 1.5 is considered great. A DSCR of 1 indicates the monthly rent exactly equals the monthly sum of principal, interest, taxes, insurance, and association dues (if any). With a DSCR below a 1, the investor likely will have to come out of pocket to cover property expenses. Take a look at the examples below for a clearer picture.
How to calculate DSCR & PITIA for Residential Properties
DSCR < 1
Principal + Interest = $1,700
Taxes = $350
Insurance = $100
Association Dues = $50
Total PITIA = $2200
Rent = $2000
DSCR = Rent/PITIA = 2000/2200 = 0.91
Since the DSCR is 0.91, we know the expenses are greater than the income of the property.
Principal + Interest = $1,500
Taxes = $250
Insurance = $100
Association Dues = $25
Total PITIA = $1875
Rent = $2300
DSCR = Rent/PITIA = 2300/1875 = 1.23
If we divide the rent by PITIA, we get a DSCR of 1.23, which indicates the property is cash flow positive.
How to calculate DSCR for Commercial Properties
Similar to the residential calculation, commercial properties use the DSCR to measure a property’s cash flow to service its debt. It is calculated by dividing the annual Net Operating Income (NOI) by the annual debt service (same thing as the annual PITIA). The formula for commercial property DSCR is:
DSCR = NOI / Annual Debt Service
For example, if a property generates an NOI of $100,000 annually and its annual debt service is $81,783, the equation would like this:
DSCR = $100,000 / $81,783
DSCR = 1.22
This is commonly expressed as 1.22x, meaning the cash flow generated from the property is sufficient or positive and is enough to cover the annual debt service. Again, a DSCR of less than 1.00x means the property cash flow is insufficient and is therefore negative in that it does not generate enough income to cover its annual debt service. Most lenders, including Visio Lending, have a minimum of 1.20x or higher.
Why DSCR Matters to Investors
The traditional way to qualify for a mortgage loan is to use your personal income and verify that you individually earn more than the mortgage payments and expenses. This becomes a problem for investors who are self-employed and cannot document their income or for investors who are building a large portfolio of rental properties. Even if an investor has a high-paying job, if they own multiple mortgaged rental properties, their money debt payments may outstrip their personal income.
Improving Your Cash Flow & DSCR
As you can see in the above samples, DSCR changes every time you adjust the numbers. Increasing your down payment to lower your loan amount is one simple way to improve your DSCR. Here are some other ideas on how to maximize your monthly profits, and therefore, improve DSCR:
- Lower Monthly Expenses: Look for areas to cut back, such as utilities or appealing your taxes. One area we strongly advise not cutting, however, is insurance. Having adequate landlord insurance is the best way to protect yourself from financial loss due to unexpected damage.
- Allow Pets: When you allow pets, you can charge a monthly pet fee. These often start at $25 per pet, depending on your area. Check out the Apartments.com Guide on Renting to Pet Owners for more information on the topic.
- Upsells: Monthly income can expand beyond rent and into services offered. Think of how you can provide internet and cable or a washer and dryer lease.
Pros & Cons of a DSCR Loan
DSCR loans are an option that have grown in popularity recently due to their use of rental income rather than personal income to evaluate whether you qualify or not. They can also be more cost-effective than hard money loans for financing an investment property. However, there are also drawbacks that should be considered when it comes to this type of loan.
- DSCR loans often have faster application and closing times without the need to submit personal financing documents
- There’s also no limit on the number of loans or properties, so scaling your business can be done more quickly if you can afford it
- Typically, they require a higher down payment (often 15-20% of the loan’s value)
- Interest rates are also higher for DSCR loans than a second home loan
- You’ll need to provide proof of experience in renting (either STR or LTR)
- Provide less overall financing than other loans, which can be particularly impactful for commercial loans
Visio Lending’s DSCR Loan Requirements
At Visio Lending, we are proud to offer DSCR loan with full 30-year terms, a streamlined qualification process, and no tax return or personal income requirements. We do, however, require:
- A minimum DSCR of 1.2
- A minimum credit score of 680
- A maximum LTV of 75%
If you are looking to finance a cash-flowing, small-balance commercial or residential rental property, we can help. Since late 2015, we have financed over $2 billion in Rental360.
Editor's Note: This post was originally published in April 2021 and has been updated in July 2022 for freshness and accuracy.