How Debt Coverage Ratio Reveals Rental Property Performance

Debt Coverage Ratio (or DCR) is a term that most connected with real estate investing for any length of time should recognize.

If not, though, then this article is for you because we'll be looking at debt coverage ratio to help you understand what it is and how its calculated

What it Is

Debt coverage ratio is a comparison between a rental income property's net operating income the total amount of the mortgage payments meant to indicate the relationship between the two amounts. It is expressed as a ratio, not as a percentage.

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).

Formulation

Where,

• 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.

Example

You estimate your first-year gross rental income of $130,000, 6.5% vacancy, and 46% operating expenses. You want to know your DCR if you finance $910,000 @5.25% for 25 years.

$68,068 ÷ 65,438
Result: 1.04

Illustration

How to Interpret the Result

The DCR will always result in one of the following three ratios:

1. Greater than 1.0. This tells the lender that there are more than enough funds to cover the debt service. Lenders typically will accept any DCR above 1.20 so this is generally acceptable.

2. Exactly 1.0. This tells the lender that there are just enough funds to cover the debt service. Lenders will typically not find this DCR good enough.

3. Less than 1.0. This tells the lender that there are not enough funds to cover the debt service. Lenders typically will turn down this loan.

Note: Since our example resulted in a debt coverage ratio of 1.04, the real estate investor can expect to cover his expenses with a few dollars to spare but might not be able to obtain this specific loan for this specific rental income property.

So You Know

Debt Coverage Ratio (DCR) is included in all three ProAPOD solutions: