This one is for any real estate investors wondering “how do you calculate DSCR on a loan for a rental property”. In this article, we’re going to give you all the background you need on this important metric, and also give you the tools you need to work out what your Debt Service Coverage Ratio (DSCR) is.
We’re also going to break down the steps to accurately calculate the DSCR for a rental property. By understanding DSCR, you can confidently navigate the non-QM loans process and make smart investment decisions that will help you achieve success in the real estate market.
If you want to save time, you can just jump straight to our free DSCR Calculator.
Let’s start with the basics: what is debt service coverage ratio (DSCR)?
Debt service coverage ratio (DSCR) is a financial metric used to assess whether the loan applicant can comfortably meet their debt obligations. That is, the monthly payments on the loan. It measures the amount of cash flow available to cover the interest and principal payments on outstanding debt.
Why is it important for real estate investors to understand the Debt Service Coverage Ratio (DSCR)?
As a real estate investor, there are a couple of very good reasons why you should have an idea of DSCR before approaching prospective lenders.
1. The calculation can affect your loan terms
Unlike a conventional mortgage, which takes your personal income into account, DSCR loans focus on the potential income and whether it will be enough to cover your monthly payment.
For lenders, knowing the DSCR is a big part of deciding your loan eligibility. As it’s the key to knowing whether you’re likely to generate enough rental income to cover your expenses, it’s a key part of the application process. Not only does it help lenders to underwrite commercial real estate loans, it also helps them to decide your maximum loan amount.
2. Calculating DSCR can improve your investment strategy
Renting out investment properties can be lucrative, but only if you understand the financial side of things. By mastering the DSCR, you can make informed decisions about your investment strategy and avoid potential financial issues.
How is DSCR calculated?
The DSCR is typically calculated by dividing the net operating income (NOI) of an entity (in this case, your investment property) by its total debt service payments (the principal and interest payments on your loan).
The NOI represents the revenue generated by the rental property, before interest and taxes are deducted. The NOI doesn’t include any operating expenses. Operating expenses typically include costs such as wages, utilities, and other day-to-day expenses necessary to run the business.
Non-operating income, on the other hand, includes revenue from sources other than the core business operations: such as rental income from other properties that you own.
So if the average monthly rent on your property is $2,500 and it costs you $600 a month in running costs, your NOI would be $1,900.
The next component is the total debt service, which refers to the company’s total annual debt payments. It includes both principal and interest payments on all outstanding loans and debts. This figure gives a clear picture of the financial burden the company has in terms of its debt obligations.
For lenders, the DSCR gives an idea of the real estate investor’s ability to generate enough cash flow to pay these debts.
A higher DSCR indicates a lower risk of default, as the investment property has a greater ability to cover its debt service payments. Lenders often use a minimum DSCR threshold to assess whether a borrower’s cash flow is enough to support additional debt.
Curious about your property’s DSCR? Try our user-friendly DSCR Calculator.
What is the minimum acceptable level of a DSCR loan?
Typically, a DSCR of at least 1.0 is considered the minimum acceptable level. This means that your investment property has enough positive cash flow to cover its debt service payments fully. However, a higher DSCR is generally preferred, as it indicates a more comfortable margin of safety.
For example, if your potential investment property has a DSCR of 1.5, it means that its net operating income is 1.5 times greater than its total debt service payments.
This suggests that the property has positive cash flow left after meeting its debt obligations. This could be used for other things, such as investing in expansion opportunities or simply building up reserves.
Of course, different lenders have different requirements for a satisfactory DSCR. It all depends on the industry and risk profile of the business. For example, traditional lenders like banks often require a higher DSCR for companies in high-risk sectors like construction or hospitality.
Before seeking financing, it’s essential as a real estate investor to understand the DSCR requirements specific to your industry and region. For example it may be different in Florida vs. New York, depending on the strength of the rental market.
What do you need to provide for a DSCR loan?
While conventional loans rely on things like your credit score to decide whether it’s likely you could make your loan repayments, private lenders providing DSCR loans look for other things.
They’re likely to ask for financial statements and projections to help them calculate your DSCR. This information is used to assess your creditworthiness and risk profile.
Private lenders may also consider other factors, such as the local real estate industry, historical performance, and the economic conditions of the neighborhood.
Aside from private lenders, who else may need to calculate DSCR?
In addition to lenders, DSCR is also a useful tool for investors and financial analysts who want to assess the financial health and stability of a property before adding it to their rental portfolios. It helps them evaluate the property’s ability to generate cash flow, manage its debt load, and identify potential risks.
By comparing the cash flow available to cover debt service payments, lenders, investors, and analysts gain valuable insight into the property’s financial strength and its capacity to take on additional debt.
Why calculate DSCR for rental properties?
When it comes to making real estate investments, it’s crucial to determine their profitability and potential for generating a steady stream of income. This is true for all property types: whether you’re looking at multifamily properties or a single-family home.
1. DSCR is one of the best methods to calculate risk vs. rewards
There are several metrics and formulas to assess the financial viability of a rental property. However, the Debt Service Coverage Ratio (DSCR) is the best because it gives investors a clear picture of a property’s ability to generate enough positive cash flow to cover its loan payments.
2. It helps you to choose the right investment properties
Once you know the DSCR on an investment property, you can weigh up the financial risks and rewards associated with the investment. By considering the DSCR before purchasing or financing a rental property, investors can make more informed decisions. This can help to avoid falling into negative cash flow, or defaulting on a traditional loan.
3. DSCR gives a comprehensive analysis of the property’s financial health
Unlike other simpler metrics, such as Cash-on-Cash Return or Cap Rate, the DSCR considers both income and debt. This makes it a more accurate and robust indicator of a property’s ability to meet its financial obligations: including mortgage payments, property management fees, vacancies, maintenance costs, and other monthly expenses.
4. Proving a high DSCR could mean better loan terms
Private lenders and financial institutions both rely heavily on DSCR when evaluating eligibility for investment property loans. A high DSCR demonstrates to lenders that the property has a positive income stream and can generate sufficient cash flow, minimizing the risk of default.
Because of this, a higher DSCR increases the chance of getting favorable loan terms, such as lower interest rates, a higher maximum loan amount and longer repayment periods. This can have a big impact the property’s profitability.
5. DSCR can help you you to build a better rental portfolio
DSCR is for more than loan underwriting. It’s also great for property appraisal. Before applying for a loan, you can calculate DSCR to avoid riskier investments.
Comparing the DSCR of different properties help you to identify which one have higher ratios, indicating greater financial stability and lower risk. This knowledge can help you to make strategic decisions, prioritizing properties that offer more predictable income streams and better returns
You can use our free DSCR calculator to compare your options, and find out which properties have the best potential for success.
6. DSCR helps you to anticipate and solve potential challenges
Let’s say you calculate the DSCR of your investment property and it falls below a certain threshold, showing that the property is struggling to cover its debt obligations. In these cases, you can take proactive measures, such as increasing rental income, reducing expenses, refinancing the loan, or securing additional funding to improve the property’s financial position.
7. Calculating DSCR can help you identify ongoing issues
Don’t stop calculating DSCR after the underwriting process and initial research phase is over. Coninually tracking DSCR can help identify potential issues in operations or financial structure. If your rental property’s DSCR declines consistently over time, it might indicate deeper issues like poor financial management, excessive debt, or an unsustainable business model. Recognizing these warning signs early allows you to take corrective action before the situation becomes unfixable.
What to consider when calculating DSCR for a rental property
There are a few important components loan programs will calculate when you apply for a Debt Service Coverage Ratio loan. Rental loans are different from traditional mortgages, as they treat your property more like a business. Your personal assets are less likely to come into the calculations. Instead, a loan calculator will look at:
1. Rental Income (or rental rates)
Rental income refers to the financial gains you get from renting out properties or assets to tenants. I
One of the primary advantages of rental income is its stability. Unlike other forms of income, such as capital gains or dividends, rental income provides a steady monthly cash flow that can be relied upon.
Knowing rent schedules makes it easier for landlords to budget and plan for future expenditures. It also helps them know whether they’ll have sufficient income to meet their monthly mortgage payments.
Rental income allows property owners to build equity as a portion of the payment goes towards covering monthly debt obligations, such as loan repayment, property taxes, and maintenance costs.
As this consistent cash flow is a big part of owning a rental property, it’s going to play a large role in the lender requirements.
2. Net Operating Income (NOI)
Net operating income is the property’s profit after deducting operating expenses. This is a crucial metric for assessing profitability and efficiency. It gives an idea of how well a rental property is doing at generating profits, as well as its ability to control costs. It excludes non-operating revenues and expenses, such as interest income, interest expenses, and taxes.
By only looking at core operations, lenders and investors can assess the profitability and sustainability of a property without one-time events skewing the data. By excluding non-operating expenses, you get a level playing field for comparing operational performance across multiple properties.
But how does it affect the loan application process?
- Higher operating costs show that the property management can manage expenses effectively and generate more profit from core operations. This gives lenders confidence that the business entity will be able to meet its monthly debt payments
- Lower operating income could indicate that they are struggling to control costs or are facing challenges in generating revenue from core operations. For lenders, this may raise concerns about the property management’s operational efficiency, profitability and ability to meet terms of the loan agreement.
3. Operating Expenses
Operating expenses represent the ongoing costs you need to pay to keep your business (or rental property) up and running and turning a profit.
Common operating expenses for a rental property are:
- Tenant screening
- Marketing and advertising
- Repairs and maintenance
- Utilities (water, trash, sewerage)
- Landscaping
- Pest control
- Landlord or property owner insurance
- Property taxes.
Conclusion: calculating DSCR can supercharge your rental business
The Debt Service Coverage Ratio is a crucial financial metric used to determine your rental property’s ability to meet its debt obligations. By analyzing the ratio, lenders and investors can assess the creditworthiness and financial health of your investment property. It can also serve as a valuable tool in making informed financial decisions and reducing potential risks associated with debt.
However, DSCR shouldn’t be the only factor when you’re making decisions about your real estate portfolio. Other financial indicators, such as profitability, liquidity, and market conditions, should also be considered.
Taking out a DSCR loan is a great way to start, or continue, building your rental portfolio. Whether you’re a first time investor or experienced landlord, taking a DSCR loan from a dependable lender can help you to secure new opportunities.
At Express Capital Financing, we provide DSCR loans with flexible and versatile terms. With our in-house underwriting, funding and draws, there are no lengthy approval processes. Our loans result in quick closing, sometimes in as little as three weeks.
Find out more about our DSCR loans and DSCR portfolio loans for those with multiple properties.
