How Debt Coverage Ratio Reveals Rental Property Performance
Debt Coverage Ratio (DCR) should be a term anyone connected with real estate investing for any length of time should recognize. However, what it says to real estate investors and lenders about an investment property might not be understood. So in this article we'll look at debt coverage ratio to help you understand the following three characteristics:
- What it is
- How its calculated
- How to intertrept the result
What it Is
Debt coverage ratio is a comparison between a rental income property's net operating income and the total amount of the mortgage payments. That is, it indicates the relationship between a property's net operating income (the rental income available after operating expenses) and the mortgage payment expressed as a ratio (not as a percentage).
How it's Calculated
The idea is to determine the number of times that annual net operating income exceeds annual mortgage payment. Therefore the math is a simple division involving both numbers (usually annual).
Net Operating Income ÷ Debt Service = Debt Coverage Ratio
- 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.
How to Interpret the Result
The DCR will always result in one of the following three ratios:
- Greater than 1.0
- Exactly 1.0
- Less than 1.0
Okay, now let's consider three examples that result in those three outcomes and show how a lender may react.
1. Greater than 1.0. 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. Or, $50,000 ÷ 40,000 = 1.25.
This tells the lender that there are more than enough funds to cover the debt service ($50,000 funds available less 40,000 mortgage payment equals 10,000). So not only are there enough dollars provided to cover the mortgage payment but 10,000 more dollars (25% more) than the payment requires.
Reaction: Lenders typically will accept any DCR above 1.20 so this should be acceptable.
2. Exactly 1.0. Okay, now let's assume that the same borrower is trying to get financing on the same property but perhaps decides to make less of a down payment and therefore borrows more money resulting in annual mortgage payments of $50,000. Or, $50,000 ÷ 50,000 = 1.00.
This tells the lender that there are just enough funds to cover the debt service. ($50,000 funds available less 50,000 mortgage payment equals 0). So there are just enough dollars provided to cover the mortgage payment but nothing would be left over for any margin of error.
Reaction: Lenders will typically not find this DCR good enough.
3. Less than 1.0. Lastly, let's assume the same scenario as above with the same annual net operating income 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. Or, $50,000 ÷ 55,500 = 0.90.
This tells the lender that there are not enough funds to cover the debt service ($50,000 funds available less 55,500 mortgage payment equals -4,500). So there are not enough dollars provided to cover the mortgage payment and would require the owner to make up the difference "out-of-pocket."
Reaction: Lenders typically will turn down this loan.
So You Know
ProAPOD's investment real estate software solutions, Agent 6 and Executive 10, both automatically compute debt coverage ratio based upon your form entries and then post it in the appropriate analysis and marketing reports. It is also included as one of the online real estate calculators in iCalculator.