The debt-service coverage ratio (DSCR) loan is a common type of debt in real estate. In short, it’s a measure of cash flow available to pay current debt obligations. One of the main benefits of a DSCR loan is that personal income calculations (think managing your DTI scenarios) are not required. The DSCR loan is a great tool for a real estate investor’s toolbox and, therefore, it’s crucial to understand how the ratio works.
As ratios go, math is needed but it’s not too complicated at all. After using it a few times you’ll be able to quickly estimate a DSCR for a property.
How do you calculate the DSCR?
The basic formula is Net Operating Income divided by Debt Service equals the DSCR
Ok, now all we have to do is dig in a little to what each of these terms mean and then you’ll have a complete understanding. First, we’ll take a look at the term Net Operating Income. Net Operating Income (or NOI) is commonly used to assess the profitability of a property.
How do you calculate Net Operating Income (NOI)?
The basic formula is Gross Operating Income plus Other Income minus Operating Expenses
How do you calculate Gross Operating Income?
Gross Operating Income is Potential Rental Income minus Vacancy Rates
What is Other Income?
Other Income can include things like coin laundry, storage units, or parking fees.
What are Operating Expenses?
Operating Expenses include insurance, property taxes, maintenance, property management fees, and anything other expense incurred in operating the rentals.
What not to include in your Net Operating Income?
Don’t include your debt service (principal and interest of your loan), income taxes, depreciation, and Capex.
What Does All Of This Mean?
Lenders will calculate the DSCR during the underwriting process when analyzing whether to lend on your investment property. The larger the DSCR ratio is, the more net operating income there is to service the debt. Different lenders have different requirements on what they want the ratio to be. Many times the ratio above 1.25 is considered strong and below 1.00 would trigger additional reserves and other requirements from the lender. Really understanding this ratio will help you calculate what you should offer on a property to make sure your DSCR is the sweet spot for your lender.