If you’re looking to get started in real estate investing, then you’ll want to familiarize yourself with the concept of a debt service coverage ratio. This ratio is commonly used when evaluating the profitability of a potential investment. It can also have a direct impact on your ability to refinance, renovate, or buy a property.
Let’s break down exactly what a debt service coverage ratio is as well as how you can use it to mitigate your risk.
What is a debt service coverage ratio (DSCR)
The debt service coverage ratio (DSCR) is a metric used by real estate investors and lenders alike to evaluate how much cash flow a property will have to pay its debt obligations.
This sounds like a complicated topic but, in reality, it’s just a way to make sure that an investment property will make more money than it will cost. After all, if you expect a property to lose money each month then it doesn’t usually make sense to buy it (unless you have a unique strategy in mind to improve its value or something similar).
As a general rule, the more income a property has in relation to its debt payments, the better.
Calculating the DSCR
You can calculate the DSCR by using the following formula:
DSCR = Net Operating Income (NOI) / Debt Obligations
The biggest thing to remember when calculating the DSCR is that net operating income includes all income and expenses associated with the property. It’s important to account for all revenue and expense sources when calculating, or else you’ll wind up with a misleading metric.
This includes revenue like:
- Rental payments
- Parking fees
- Storage fees
- Vending or laundry machine income
The other part of the NOI equation is to subtract the expenses. This includes expenses like:
- Management fees
- Cleaning fees
However, remember that the NOI calculation does not include debt payments.
For example, let’s say that you have a property that you expect to generate $5 million in annual income after accounting for all expenses. If the property has annual debt obligations of $3.5 million then the debt service coverage ratio would be 1.43x ($5,000,000 / 3,500,000). As a general rule, most lenders will look for a DSCR ratio of 1.25-1.50x.
Understanding the DSCR
The debt service coverage ratio is measured on a scale where 1.0 is considered to be the middle. Anything less than 1.0 is considered risky as the property is not generating enough income to pay for its debt. On the other hand, anything higher than 1.0 is considered profitable since the property will have enough cash coming in to pay its debt.
As an investor, you want the DSCR ratio to be as high as possible since it indicates a more profitable investment. Additionally, you can expect almost all lenders to inquire about a property’s DSCR. If you know that a property’s DSCR is strong then it will be easier to get funding. But, on the flip side, if the DSCR is under 1.0 then you will likely have a hard time getting funding.
DSCRs are important regardless of which asset class you operate in (multifamily, office, hospitality, retail, self-storage). They will also be considered regardless of whether you are trying to buy a new property, refinance an existing one, or pay for renovations.
Using it to mitigate risk
A property’s debt service coverage acts like a barometer for the health of a property. If the DSCR is low, it can be a sign that the expenses on the property need to be reduced or the rents need to be increased in order to boost profitability.
Also, remember that a property’s DSCR is sort of a screenshot in time depending on when you perform the calculation. But, the DSCR will fluctuate over time and it’s possible for you to improve a property’s DSCR. You can do this by reevaluating the property’s lease rates, vendor contracts, and potential improvements to identify any areas for improvement.
Let’s say that you slowly improve a property over time and, subsequently, increase the rent. This will naturally give you a higher DSCR since you will have more revenue coming in while your debt obligations stay the same (assuming that expenses stay consistent). If this happens, then you will be able to leverage this higher ratio to refinance the existing loan on the property at a lower rate or better terms. This is possible because, if your DSCR has improved, then lenders will view the property as more attractive and be willing to approve a better loan.
We hope that you’ve found this article valuable when it comes to understanding the debt service coverage ratio. If you’re interested in learning more please subscribe below to get alerted of new articles as we write them. Also, please follow along with Avatar Equity and Sachin Maskey on social media to get alerted of any updates.
Sachin Maskey is a physician, real estate investor, philanthropist, and entrepreneur. He has over 17 years of expertise in the medical industry as a family medicine specialist. Outside of medicine, he is the founder of the commercial real estate investment firm Avatar Equity as well as the Dhana Yoga Foundation. You can follow along with Sachin on Instagram, Facebook, and LinkedIn.