The Debt Coverage Ratio
Debt Coverage Ratio (or DCR) is a common factor with real estate investing because much of the investment properties purchased involve real estate debt.
As a result, real estate investors use DCR to track and compare debt-related outcomes, and lenders use it to measure their financial risk in the event that they should finance the property.
In a nutshell, debt coverage ratio is a comparison between a rental investment property's net operating income and the total amount of the mortgage payments expressed as a ratio (not as a percentage).
From a lender's point of view, of course, computing a DCR is particularly important because, as stated, it concerns the amount of financial risk they will take with regard to financing or refinancing real estate investments. In other words, DCR helps mortgage lenders determine whether any given rental investment property generates enough cash to cover its mortgage payment.
The idea is to determine the number of times that annual net operating income (NOI) exceeds annual mortgage payment. Therefore the math is really a simple division involving the property's annual NOI and the proposed debt service.
Debt Coverage Ratio = Net Operating Income / Debt Service
- Net operating income is the total amount of gross operating income (rental income less vacancy allowance) less the property's total amount of operating expenses.
- Debt service is the required annual payments of principal and interest.
Let's assume that an investor finds a real estate investment property that generates an annual net operating income of $50,000 and is requesting a mortgage that would result in annual payments of $40,000.
Net Operating Income / Debt Service = DCR
$50,000 / 40,000 = 1.25
This tells the lender that there are more than enough funds to cover the debt service. Let's check it: $50,000 (funds available) less 40,000 (mortgage payment) = 10,000. So in this case, not only are there enough dollars provided to cover the mortgage payment, there are 10,000 more dollars (25% more) than the payment requires. This is a good thing.
Okay, now let's assume that the same borrower is trying to get financing on the same property with the same NOI of $50,000. But in this case perhaps he decides to make less of a down payment which in turn means more money borrowed and therefore results in annual mortgage payments of $50,000.
$50,000 / 50,000 = 1.00
This tells the lender that there are just enough funds to cover the debt service. Let's check it: $50,000 (funds available) less 50,000 (mortgage payment) = 0. So in this case, there are just enough dollars provided to cover the mortgage payment, but nothing would be left over for any margin of error. This is typically not good enough.
Lastly, let's assume the same scenario as above with the same annual net operating income of $50,000. But in this case perhaps the borrower must pay a higher interest rate for the loan and therefore it increases his annual payments to $55,500.
$50,000 / 55,500 = 0.90
This tells the lender that there are not enough funds to cover the debt service. Let's check it: $50,000 (funds available) less 55,500 (mortgage payment) = -4,500. So in this case, there are not enough dollars provided to cover the mortgage payment and would require the owner to make up the difference "out-of-pocket." This is absolutely not good enough.
Rule of Thumb
As a quick point of reference, just remember that 1.0 is break-even. Therefore any ratio that's higher means more than enough to cover the mortgage payment, whereas any ratio that's lower means less than enough to cover the mortgage payment. Naturally what ratio a lender is willing to accept is up to the lender, but don't be surprised to find that most look for a DCR of at least 1.20.
So You Know
All three of ProAPOD's real estate software solutions automatically compute debt coverage ratio. You simply fill in the forms and the result is posted in the appropriate reports. It is also available in iCalculator.