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The phrase “debt-service coverage ratio” or DSCR is about as clear as mud, yet it is simply 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, at what makes a good DSCR and, at why it matters to lenders and investors.
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.
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. While it varies between lenders, typically anything above a 1.2 is considered good, and anything above a 1.5 is considered great. Take a look at the examples below for a clearer picture.
Principal + Interest= $1,700
Total PITIA= $2200
Since the DSCR is .91, we know the expenses are greater than the income of the property.
Principal + Interest= $1,500
Total PITIA= $1875
If we divide the rent by PITIA, we get a DSCR of 1.23, which indicates the property is cash flow positive.
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.
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. You could also shop insurance vendors to lower your premium (though never skimp on insurance), appeal your property taxes to reduce your tax bill, or rehab your property to increase the monthly rent.
At Visio, we typically require a minimum DSCR of 1.2. However, for those investors looking to purchase or refinance in hot markets where the rents have not caught up to the property values, we offer a No DSCR Loan Product. A No DSCR loan is a loan where the same ratio is considered but is not the only, or maybe even not the primary, consideration the lender uses to price and size the loan.
The Rental360 No DSCR boasts:
Similar to the residential calculation, for commercial properties, DSCR is the measure of 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). Here is the formula:
DSCR= NOI/Annual Debt Service
For example, a property generates an NOI of $100,000 annually and its annual debt service is $81,783, so the equation would like this:
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 have a minimum of 1.20x or higher.
If you are looking to finance a cash-flowing, small-balance commercial or residential rental property, we can help. We offer 30-year terms, no balloons, and no personal income verification or tax documents. Since late 2015, we have financed over $1 billion in Rental360.