DEBT SERVICE COVERAGE RATIO or DSCR

• What is it?
• Who came up with this?
• Why do we need to know another math equation?
• How can it save a deal? or a client?

Wikipedia defines DSCR as this:

The debt service coverage ratio, or debt service ratio, is the ratio of net operating income to debt payments on a piece of investment real estate. The higher this ratio is, the easier it is to borrow money for the property. The phrase is also used in corporate finance and may be expressed as a minimum ratio that is acceptable to a lender…

Here’s what you need to know:

DSCR

Take the Net Operating Income for the year and divide it by the Total Annual Debt Service. or your income over your mortgage payments for the year. Easy?

Not always. Net Operating Income on the property can have MANY variables depending on property type so know what you’re working with. For instance. If your client is purchasing a Commercial NNN (Triple Net) property, then the TENANT pays all the expenses!… so effectively the NOI would be the rents brought in… If your client is buying an office building functioning as an executive suite center, then expenses would be ENORMOUS but still the tenant would be paying extra in their rent to cover your expenses.

Now I have just described DSCR on Commercial Real Estate… but it works on Residential as well!

In Commercial Real Estate, Lenders on Owner Occupied properties usually require .85-1.15 DSCR… meaning that the NOI on the property could actually be 85% of the Debt… or NEGATIVE CASH FLOW… why? because the owner is deriving income from being in that property! Investment properties usually require a DSCR > 1.2…some go as high as 1.5 depending on the use. An A+ office building will be a safer bet so the DSCR could be lower… a Marina or Bar is more of a risk so the lender will require a higher DSCR.

In Residential Real Estate, usually DSCR will be under 1 because if it is a home - primary, 2nd home, vacation whatever - you do not receive income on that property. Even many duplexes will be negative because the 2nd unit that the owner does not occupy will likely not bring in enough rent to cover the entire mortgage.

BUT… can we still gain something by knowing and using this? SURE!

• First of all: don’t worry about it for your clients unless they start saying that maybe they’ll buy a property in Florida and want to rent it out for 1/2 the year. Then DSCR can be used to show them how much the rent will subsidize their debt payments.
• Second: You can use this formula anytime your client wants to rent out a property they own or want to buy. Say your client is in a starter home - a nice condo with great rental potential. They want to step up into a single family home but want to rent out their condo. You can do a DSCR Analysis to see if it will work.
• Third: Now you’re using a much better formula for showing the worth of an investment than Gross Rent Multiplier or Cap Rates which can be arbitrary. The DSCR will help you make those formulas more valuable.

You can do a DSCR Analysis to see if it will work? Isn’t that simple math?? yes and no. Consider this: When applying for a mortgage, we list all properties owned by the borrower on the 1003 application. BUT… because of maintenance and vacancy, most lenders will only credit a borrower for 75% of the rental income…. unless they can provide a lease proving that the tenant pays for everything including maintenance and has a multiyear lease.

What will it show??

… essentially you could use the formula to show the Internal Rate of Return (IRR) on the investment. Borrower puts $100,000 down on property. DSCR is 1.2 or 20% more cash coming in than going out. That 20% multiplied by the NOI shows what your profits are pre-taxes (in most case). that dollar amount comes out to say $5,000 which means that the property is making your client 5% a year! That’s not bad at all. If the property appreciates an additional 5%, then the real IRR can be calculated at the end of the holding period.

So what have I just explained? An EASY formula that will let all Realtors help their clients wanting to invest in real estate.

• If the DSCR < 1 - then you have negative cash flows… likely a bad investment
• If DSCR = 1 - then you have no gains and no losses - DSCR = 1 = breakeven
• If DSCR > 1 - then you have positive cash flows.

Just remember, breakeven in residential for purposes of a mortgage is more like a DSCR of 1.34.

BUT… if DSCR < 1 is there a way to make it > 1?? SURE!! Change the leverage equation… meaning put more money down. All the real estate “experts” from Kiyosaki to Trump say that real estate is great because you can control so much with so little. They further explain that you should put as little down as possible. AS POSSIBLE is the operative word. Kiyosaki says NEVER go into a negative cash property.

The fix? EXCEL SPREADSHEETS like I use.

If 20% down is negative cash flow… then I adjust the down payment until I get the DSCR that I need. If the transaction is still feasible, GREAT… if the borrower just can’t bring an extra $25,000 to the table them I have to inform them whether or not I can get them the loan without the money. If so, I can calculate for them what the rents and expenses need to be changed to for them to positively cash flow…

Sounds great? How do I start? Easy… when you’re working on a condo sale for an investment… do a search of market rents in the area. If you see a ton of listings, discount the market rent so you know you can get someone in. Then if the property still makes sense, you come out a hero.

Or you could always call me and I’ll do it for you!

More Real Estate Industry News You Can Use from
David A. Podgursky, MBA
The Mortgage Go To Guy!
Your Source for Residential and Commercial Mortgage Loans in Florida

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