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Debt Service Coverage
Ratio (DSCR)
The most important ratio to
understand when making income property loans is
the debt service coverage ratio. It equals Net
Operating Income (NOI) divided by Total Debt
Service. To understand the ratio it is first
necessary to understand the numerator and the
denominator. Let's take a look at net operating
income (NOI) first.
Net
operating income is the income from a rental
property left over after paying all of the
operating expenses:
|
Gross Scheduled Rent |
$100,000 |
|
Less 5%
Vacancy & Collection Loss |
$5,000 |
|
|
________ |
|
Effective
Gross Income: |
$95,000 |
|
Less
Operating Expenses |
|
|
Real
Estate Taxes |
|
|
Insurance |
|
|
Repairs &
Maintenance |
|
|
Utilities |
|
|
Management |
|
|
Reserves
for Replacement |
|
|
Total Operating Expenses: |
$30,000 |
|
Net
Operating Income (NOI) |
$65,000 |
Please note that lenders always
insist on some sort of vacancy factor regardless
of the actual vacancy rate in an area to cover
collection loss. In addition lenders always
insist on using a management factor of 3-6% of
effective gross income, even if the property is
owner-managed. Their logic is that they would
have to pay for management if they took back the
property. Finally, NOTE THAT WE HAVE NOT
INCLUDED LOAN PAYMENTS AS AN OPERATING EXPENSE.
Next let's look at the
denominator, Total Debt Service. This includes
the principal and interest payments of all loans
on the property, not just the first mortgage.
NOTE THAT WE HAVE NOT INCLUDED TAXES AND
INSURANCE. They were already accounted for above
when we arrived at net operating income (NOI).
To calculate the debt service
coverage ratio, simply divide the net operating
income ((NOI) by the mortgage payment(s). For the
sake of simplicity, let us assume that there is
only one mortgage on the property:
$500,000 First Mortgage
11% Interest, 30 years amortized
Annual Payment (Debt Service) = $57,139
DSCR = Net Operating Income (NOI) = $65,000
Total Debt Service $57,139
DSCR = 1.14
Obviously the higher the DSCR,
the more net operating income is available to
service the debt. From a lender's viewpoint it
should be clear that they want as high a DSCR as
possible.
The borrower, on the other hand,
wants as large a loan as possible. The larger
the loan, the higher the debt service (mortgage
payments). If the net operating income stays the
same, and the loan size and therefore the debt
service increases, then the lower the DSCR will
be.
Life insurance companies are
very conservative and generally require a 1.25
or 1.35 DSCR. This means that their
loan-to-value ratios are low. Savings and loans
(S&L's) generally only require a 1.20 DSCR, and
sometimes will accept a DSCR as low as 1.10.
A DSCR of less than 1.0 would be
a situation where there would actually be a
negative cash flow. A DSCR of say .95 would mean
that there is only enough net operating income (NOI)
to cover 95% of the mortgage payment. This would
mean that the borrower would have to come up
with cash out of his personal budget every month
to keep the project afloat.
Generally lenders frown on a
negative cash flow. Some lenders will allow a
negative cash flow if the loan-to-value ratio is
less than around 65%, the borrower has strong
outside income such as an electronic engineer,
and the size of the negative is small. Lenders
rarely allow negative cash flows on loans over
$200,0000
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