What Debt Coverage Ratio Says About a Real Estate Investment
Anyone connected with real estate investing for any length of time has certainly come across the Debt Coverage Ratio (or DCR as it's commonly shown). But 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 what DCR is, how its formulated, and most importantly, why investors and lenders care.
What It Is
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).
In other words, it indicates the relationship between a property's net operating income (the rental income available after the operating expenses) and mortgage payment.
Why do lenders care? DCR helps mortgage lenders determine whether any given rental investment property generates enough cash to cover its mortgage payment as a measurement of their financial risk in the event that they should finance the property.
Why do investors care? DCR helps them to track and compare debt-related outcomes on various real estate investment opportunities.
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.
Okay, now let's consider the following three examples so you understand how to interpret the DCR result.
Example (above 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.
$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) 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. This is a good thing.
Example (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.
$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) 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. This is typically not good enough.
Example (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.
$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) 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." This is absolutely not good enough.
Rule of Thumb
What ratio a lender is willing to accept is up to the lender, but don't be surprised to find that most lenders look for a debt coverage ratio of at least 1.20.
So You Know
ProAPOD's investment real estate software solutions automatically compute debt coverage ratio based upon your form entries and then post it in the appropriate analysis and marketing reports. DCR is also available in iCalculator.