DSCR or Debt-Service Coverage Ratio loans enable real estate investors to qualify based on rental income generated rather than personal income. These loans are ideal for self-employed investors, investors with multiple mortgaged rental properties, and investors looking to grow their portfolios rapidly. Let's take a closer look at:
DSCR Loan Property Types
Why are DSCR Loans Significant to Investors?
What Makes a Good DSCR
DSCR Examples
What to Look for in a DSCR Lender
Unlike a consumer or owner-occupied mortgage loan, but similar to a commercial real estate mortgage, a DSCR loan is underwritten based on property-level cash flow, rather than personal income. DSCR or Debt-Service Coverage ratio is a tool to help lenders understand a borrower's ability to pay back a loan based on the monthly rental income of the property. DSCR is a simplified way to measure cash flow and is calculated by dividing the monthly rent by the monthly principal and interest payments, taxes, insurance, and association dues (PITIA). ratio is a tool to help lenders understand a borrower's ability to pay back a loan based on the monthly rental income of the property.
For a commercial or multi-family property, DSCR 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 = Net Operating Income / Annual Debt Obligations
For example, if a property generates a Net Operating Income of $100,000 annually and its annual debt service is $81,783, the equation would like this:
The annual debt service in this example is less than the Net Operating Income, which makes the monthly cash flow positive.
DSCR loans typically can be used for the following property types:
- Single-family (1-4 unit) residential
- Vacation or short-term rentals
- Commercial or multifamily property
DSCR loans typically cannot be used for the following property types:
- Rural properties
- Properties with square footage of less than 750 square feet
- Condotels
- Manufactured housing
- Dome homes
- Log cabins
Also referred to as investment property loans, Non-QM loans, and rental loans, among other synonyms, DSCR loans have become quite trendy recently. So what is all the buzz about? While it is possible for investors to obtain a conventional loan or funds through a small bank, this financing is tedious to qualify for and has substantial liquid reserve requirements. DSCR Loans, on the other hand, are specifically designed for the professional real estate investor to use cash flow generated by the property as a qualification. Let's take a closer look.
Experienced real estate investors with multiple mortgaged investment properties and self-employed investors without W2's often have difficulty meeting conventional loan criteria. The credit, reserve, and income requirements of conventional loans are strenuous. Further, they are underwritten using Debt-to-Income ratio or DTI, which looks at your personal income compared to your personal debt. If you are trying to finance the purchase of a rental property with a conventional loan, the payment for the new loan will be included in the debt portion of your debt-to-income calculation. Whether you can offset that new monthly payment with a portion of the expected rent on the new investment property will depend on how well you can document the actual or expected rents from the property.
Investors that have a lot of personal income from non-investment property sources, may be able to cover the “cash flow gap” on their DTI calculation up to some point. Investors that are self-employed or have a lot of investment properties may not have income from other sources to cover this gap. Using debt service coverage ratio eliminates DTI from the underwriting and instead focuses on the rental income from the subject property relative to the investment property monthly payments.
Many experienced investors prefer to borrow through an LLC or corporation to protect their identity and other investments. This adds an extra layer of protection to the investor's personal assets for any unfortunate incidents on the property. Conventional loans can only be obtained in an individual(s) name.
Even if an investor has enough personal income to support multiple mortgaged rentals, with conventional loans you are maxed out at ten loans. Most DSCR lenders do not have set limits but instead use common sense when evaluating an investor's maximum credit exposure.
When applying for a conventional mortgage, you have to gather all of your pay stubs, bank and asset statements, and tax documentation. The underwriters are going to dive deep into your personal financial documents and history, which is time consuming and tedious. Any missing documentation or schedules in your tax returns can lead to lengthy delays. DSCR lenders focus on the value of the property and the expected cash flow of the property, plus the quality and depth of your credit. Most DSCR lenders will not ask you for documentation to verify your employment, income or assets (beyond required liquid reserves).
A debt service coverage ratio of 1.2 is solid , and anything above a 1.5 is strong. A DSCR ratio of 1 indicates the rent exactly equals the monthly sum of principal, interest, taxes, insurance, and association dues (if any). With a debt service coverage ratio below a 1, the investor will be subsidizing the PITIA with cash from other sources.
Let's look at some examples for a clearer picture.
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Principal + Interest= $1,800
Taxes= $250
Insurance= $150
Association Dues=$35
Total PITIA= $2235
Rent= $2100
DSCR= Rent/PITIA=2100/2235=0.94
Since the DSCR is .94, we know the PITIA is greater than the monthly rent from the property, indicating negative cash flow.
Principal + Interest= $1,500
Taxes= $350
Insurance= $150
Association Dues=$100
Total PITIA= $2100
Rent= $2100
DSCR= Rent/PITIA=2100/2100=1.0
Since the DSCR is 1.0, we know the PITIA is equal to the monthly property rent.
Principal + Interest= $1,600
Taxes= $250
Insurance= $150
Association Dues=$35
Total PITIA= $2,035
Rent= $2350
DSCR= Rent/PITIA=2350/2035=1.15
If we divide the rent by PITIA, we get a DSCR of 1.15, which indicates positive cash flow.
Simply put, the debt service coverage ratio is a ratio, and it can be manipulated by changing the numbers. Here are ways to improve your debt service coverage ratio:
One surefire way to improve your DSCR, is to charge more rent for your rental property. An increase in rental income will give you more cash flow to pay your monthly mortgage payments, and therefore improve DSCR.
Lowering your interest rate will lower your monthly mortgage payments and therefore your DSCR. The best ways to guarantee a lower interest rate are to increase your down payment and improve your credit score.
When comparing DSCR lenders, here are some considerations.
It is important to know exactly what your costs will be for the loan. The last thing you want is to end up at the closing table with unexpected costs. Most lenders charge an origination fee and one or more administrative fee (underwriting fee, documentation fee).
This may seem obvious, but it does vary between lenders. For instance, some lenders have DSCR Loan Programs for vacation rentals and others do not. Other common variations include warrantable vs. non-warrantable condos and multi-family vs. single-family homes.
In our opinion, this is the most important consideration. Lenders who work with investors often understand the nuances associated with financing and have programs tailored to help investor needs. There are a lot of new DSCR lenders on the market. Here are some things you can look for to help hone in on the most experienced lenders:
Ask about the number of DSCR loans they have closed
Ask how long they’ve been offering and closing DSCR loans
Ask whether they have a dedicated team of operations personnel that process and underwrite their DSCR loans
Ask about their property insurance requirements, because they typically are materially different for investment properties as compared to owner-occupied properties
Ask about their prepayment penalty or rate buy-down options. DSCR loans almost always have a prepayment penalty
Ask about the ability to finance in an LLC or corporate entity
If you are an investor and looking to obtain a DSCR mortgage, make sure you meet these basic requirements:
Minimum Credit Score Required: Most DSCR lenders require a 680 credit score with better rates for higher credit. Most lenders also have minimum tradeline requirements, including both amount and duration. Lenders also will consider whether you have any other significant credit events on your credit report, such as foreclosures, bankruptcies or past due payments.
Minimum Down Payment or Equity: Maximum loan-to-value on purchase loans typically is 70%-80% and on refinances is 65%-75% depending on property type, credit and DSCR.
Minimum Property Value: Most lenders have a minimum property value of $150k.
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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 are easier to qualify for than an agency or bank loan and are 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.
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DSCR loans often have faster application and closing times without the need to submit personal financing documents.
There’s also more flexibility on the number of loans or properties, so scaling your business can be done more quickly if you can afford it.
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Typically, they require a higher down payment (often 15-25% of the property's value).
Interest rates and lender fees are also higher for a DSCR mortgage than a second home loan.
You’ll need to provide proof of experience in renting (either STR or LTR)).
As an example, personal income history is not a consideration when underwriting DSCR loans.
For a DSCR loan, an evaluation is needed of comparable rents in the area is needed in addition to the standard property appraisal report.
Often a real estate investor finances properties in an entity, which in itself has some lending nuances. For instance, there are necessary entity documents.
This is just a sampling of the many nuances associated with a DSCR mortgage. Visio Lending has over a decade in mastering this niche market with over $2.1 billion in DSCR Loans originated, including over $697 million in vacation rentals.
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Low documentation; no personal DTI, no tax returns;
Full 30-year terms with no balloons; and
The ability to protect your identity by financing through a corporate entity
Common sense underwriting of your short-term rents
We finance DSCR loans in 38 states and Washington D.C.: Alabama, Arkansas, Arizona, California, Colorado, Connecticut, Florida, Georgia, Hawaii, Iowa, Illinois, Indiana, Kansas, Kentucky, Louisiana, Massachusetts, Maryland, Maine, Michigan, Missouri, Mississippi, Montana, North Carolina, New Hampshire, New Jersey, New Mexico, New York, Ohio, Oklahoma, Pennsylvania, South Carolina, Tennessee, Texas, Virginia, Washing, Wisconsin, West Virginia, and Wyoming
Visio Lending is the nation's premier lender for buy and hold investors offering, long-term loans for SFR and commercial rental properties, including vacation rentals.