DEBT SERVICE COVERAGE RATIO
Steps to Calculating the Debt Service Coverage Ratio (DSCR)
The most important ratio to understand when making income property loans is the debt service coverage ratio. Here is the formula:
DSCR = Net Operating Income (NOI)/ Total Debt Service
To better understand the Debt Service Coverage Ratio is to understand the numerator and denominator. Letís take a look at the net operating income first.
Net Operating Income is the income from an income property less all the operating expenses:
Scheduled Rents $150,000
Less 5% Vacancy & Collection Costs $7,500
Effective Gross Income $142,500
Total Operating Expenses $35,000
Net Operating Income (NOI) $107,500
Please remember that most lenders insist a management factor of 3-6% of the effective gross income even if the property is managed by the owner. The reason for this is the lender figures they will have to pay for the management of the property if they took back the property.
Lenders require a vacancy factor of usually 5-10% of the gross income to cover any collection cost or vacancy cushion.
Now letís figure out the denominator. The Total Debt Service includes all the principal and interest payments, (on all mortgages) on the property. Do not add in the insurance or tax expense, they were already accounted for in the Net Operating Income (NOI).
Finished! Now divide the Net Operating Income (NOI) by the mortgage payment(s). Here is an example:
Net Operating Income = $107,500
Total Debt Service (Mortgage payments) = $80,000
DSCR = $107,500/ 80,000 = 1.34%
DSCR = 1.34%
Most lenders require that the DSCR be higher than 1.10%, certain factors like the loan to value may warrant going below 1.10% and even below 1% if the loan to value is around 65%.