When I first started investing in income producing real estate. There was so much I didn’t know or even understand. My first several properties that I purchased I just wanted to be able to charge and earn in rental income twice as much as the mortgage payment. I wasn’t overly sophisticated on all of the numbers. This was my simple measurement.
As I advanced over the years and started investing in multifamily properties. I learned about Debt Service Coverage ratio (DSCR). The Debt Service Coverage Ratio (DSCR) is a critical metric in real estate investing, especially for income-producing properties.
It measures the property’s ability to cover its debt obligations (mortgage payments) with its operating income. In other words, it assesses whether the property generates enough income to service its debt, making it a crucial factor for both lenders and investors.
Here’s why DSCR is important:
- Lender’s Perspective: Lenders use the DSCR as a risk assessment tool when deciding whether to approve a loan application. They want to ensure that the property’s income is sufficient to cover the mortgage payments comfortably. A higher DSCR provides lenders with greater confidence that the property can handle the debt, reducing the risk of default.
- Investor’s Perspective: From an investor’s point of view, a healthy DSCR indicates a lower risk of financial distress and the potential for stable cash flow. It provides reassurance that the property’s income is adequate to meet the debt obligations, allowing the investor to focus on other aspects of the investment.
How do you calculate DSCR:
The Debt Coverage Ratio (DSCR) is calculated by dividing the property’s Net Operating Income (NOI) by its total Debt Service. The formula for calculating DSCR is as follows:
DSCR = Net Operating Income (NOI) / Total Debt Service
Here’s a breakdown of the components used in the formula:
- Net Operating Income (NOI): This is the property’s total income generated from operations, such as rental income, minus all operating expenses but before accounting for financing costs and income taxes. The formula to calculate NOI is:
NOI = Total Income – Total Operating Expenses
- Total Debt Service: This represents the total amount of debt payments the property must make during a specific period. It typically includes both principal and interest payments on the mortgage loan.
Once you have the NOI and Total Debt Service figures, you can use the formula to calculate the DSCR. The resulting value will indicate how many times the property’s operating income can cover its debt obligations.
For example, if the property has a Net Operating Income of $100,000 per year, and the Total Debt Service is $80,000 per year, the DSCR would be:
DSCR = $100,000 / $80,000 DSCR = 1.25
In this example, the DSCR is 1.25, meaning the property’s operating income can cover its debt obligations 1.25 times. A DSCR above 1.0 indicates that the property generates enough income to cover its debt payments, providing a margin of safety for the investor or lender
The desirable DSCR can vary depending on several factors, including the property type, location, market conditions, and the risk appetite of the investor. Generally, a DSCR of 1.0 means that the property’s net operating income is just enough to cover the debt payments, leaving no buffer for unexpected expenses or income fluctuations. In this case, any minor financial setback could lead to default.
To be considered a successful investment, most investors and lenders prefer a DSCR higher than 1.0, typically in the range of 1.2 to 1.5 or even higher. A DSCR above 1.2 means that the property generates 20% more income than the required debt payments. A higher DSCR implies a more conservative and secure investment because it offers a greater margin of safety in case of unexpected income fluctuations or expenses.
It’s essential to note that a good/safe DSCR can vary depending on the risk tolerance and investment goals of the investor. A more risk-averse investor might seek a higher DSCR, while a more aggressive investor might accept a slightly lower DSCR for the potential of higher returns.
Ultimately, DSCR should be considered alongside other financial metrics, such as Cash-on-Cash Return, Return on Investment, and Net Operating Income, as well as an in-depth analysis of the local real estate market and economic factors to make a well-informed investment decision
To your success and your future.
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