One of the most critical numbers in real estate walks around hidden under the sheep’s clothing of a four letter acronym - DSCR.
We first heard about Debt Service Coverage Ratio (DSCR) as single family investors. That was back when we spent our days cold calling single family home owners to see if they wanted to sell their property off market at a discounted price for a “stress-free process.” Back then, understanding how to calculate DSCR saved our tails when we were presented with a rental property opportunity that didn’t make sense.
After we made the leap into the multifamily space, we realized DSCR had a similar level of importance, but there was a twist. And with the price tags going from hundreds of thousands for a ranch home to millions of dollars for an apartment complex, the stakes couldn’t have been higher.
So why should we care about DSCR?
More Than A Four Letter Acronym…
We won’t bore you with a ton of financial jargon. Simply put, a debt service coverage ratio is how much capital is available to pay the debt on a given property. This capital is used to pay off the payments on the principal and the interest.
In the single family space, we understood this metric as a key factor to determine cash flow. As long as the house generated more rental revenue than the principal and interest on the debt we used to purchase the property, as well as taxes and insurance (not included in DSCR), it was a deal!
In the multifamily space, we also realized that lenders care about DSCR - a lot. DSCR tells them whether or not we as borrowers can afford to pay them back for the loan we took out to buy any given multifamily property.
But how do we calculate DSCR?
Putting The Property To The Test…
When we go to calculate the DSCR for a multifamily property we’re underwriting, we use this simple formula.
The Property’s Net Operating Income / The Yearly Debt Payment
Source: Deal Check
Another gold nugget we learned was that in order to be considered a breakeven DSCR - and therefore have any chance of “penciling out” - a property needs to have a DSCR of at least 1.0x.
The higher the DSCR, the better. But why?
Why More is ALWAYS Better (For DSCR)…
If we’re underwriting a property with a relatively high DSCR, that means that we’re going to have an easier time obtaining favorable loan terms from a lender. This typically means a DSCR of 1.5x or higher. A DSCR loan, a loan from a lender where the main factor taken into account is the property’s DSCR, usually moves more quickly than other kinds of multifamily loans. These loans also typically don’t cap us on how much cash we can take out, which is helpful if we encounter an unexpected or big expense at the property.
So it’s clear that we look for a high DSCR ratio in our underwriting of any property we’re looking at.
But we’d be remiss if we didn’t explain why a low DSCR is something we try to avoid.
Risks of a Low DSCR
A DSCR ratio below 1.25x is considered low. A low DSCR ratio means that a property is in danger of not being able to make its annual debt payments. A lender cares about this because every loan they give out is an investment for them. So the less likely a borrower is to make the principal and interest payments on the money the lender gave them, the less likely the lender is to redeem their investment.
DSCR Ratios CAN Change Overtime…But How?
As investors, we can influence the DSCR ratio at a property for better or for worse.
One way we can do this is by increasing the revenue a property generates. Value-add investors like us do this through rental increases and property renovations that justify these rent bumps.
Decreasing operational costs also allows us to increase the DSCR. This can be through improving efficiency at the property, or cutting back on expenses.
Making debt payments also improves the DSCR ratio by decreasing the debt on the property.
With changing interest rates, we’ve been hearing more conversations centered around debt and the implications of the changes we’re experiencing in the economy. DSCR is a factor that we’ve understood as critical in the success of a real estate deal since we started wholesaling houses years ago. But as the tides of the industry shift, the importance of this number has only increased.
And now, you know more about why.