Real Estate Financing Basics: Debt Coverage Ratio

The Debt Coverage Ratio (DCR) or Debt Service Coverage Ratio (DSCR) is a widely used ratio in the case of financing buy-to-let property and in general income-producing property.  This is the case because this ratio is one of the two critical indicators used by bank loan officers in evaluating mortgage loan requests by property investors.

The other critical indicator used is the Loan-to-Value (LTV) ratio, which as the term indicates is the ratio of the loan amount over the value of the property secured by the loan.

The Debt Coverage Ratio is the ratio of the annual Net Operating Income (NOI) over the annual debt service or the annual mortgage payment in the case of real estate.  For example, if the property has an annual NOI of $100,000 and a loan with an annual mortgage payment of 80,000, then the DCR will be:

DCR = NOI / Debt Service =100,000/80,000 =1.25

The calculated DCR of 1.25 implies that the property’s net operating income is 1.25 higher than the annual payment required to service the mortgage loan. If the DCR is smaller than 1, it indicates that the property produces insufficient income to cover both operating expenses and the mortgage payment, which is what lenders want to avoid because in that case, the investor will need to use own funds to repay the loan. Within this context, lenders are usually requiring a DCR of at least 1.2, which means that the property net operating income is at least 1.2 times higher than the mortgage payment. For example, Freddie Mac requires a minimum DSCR of 1.25 for acquisition or refinance of major multifamily acquisitions.

The minimum DCR required by banks varies depending on prevailing local and global economic and real estate market conditions. In particular, in times of recessionary economic conditions and weak real estate markets, banks are requiring a higher DCR, so they are protected against future declines of the property’s net operating income, which are more likely in such a market environment.

If the property has more than one mortgages then the debt service used to calculate this ratio will be the sum of the annual payments due for all loans.

Required Debt Coverage Ratio and Maximum Loan

Obviously, if the property investor knows the minimum acceptable DCR by a lender and the NOI produced by the property he/she can calculate the annual mortgage payment that is implied by these two numbers (property NOI and required DCR by lender). This can be calculated using the formula below and represents the maximum annual loan payment that the lender would be willing to accept for a loan secured by the property under consideration:

Maximum Allowable Mortgage Payment = NOI / DCR

Thus, using the example above, if the property NOI is $100,000 and the lender is not allowing a DCR lower than the 1.25, then the maximum mortgage loan a property investor can get will have an annual installment of:

Maximum annual loan payment = 100,000 / 1.25 = 80,000

Debt Coverage Ratio and Investing for High Returns

When investing for high returns borrowing can play a crucial role in boosting the investor’s return on equity.  In the context of such strategy, when there is positive leverage, the higher the borrowing as a percent of property value the higher the positive impact on investor return. However, real estate investors need to bear in mind that the higher the loan amount as a percentage of the value of the property, the higher the risk of default due to higher monthly installment and the higher the interest rate of the loan (which may lead eventually to negative leverage).

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