Debt Service Coverage Ratio for Landlords

Commercial lenders use what's known as the "debt service coverage ratio", or DSCR, as one of the criteria for approving loans on rental property. Also known as the "debt service ratio", this magical number can mean the difference between getting approved or rejected for mortgage financing.

The debt service coverage ratio can be defined as the ratio of an income property's net operating income to its mortgage (or debt) payments. From a lender's standpoint, the higher this ratio is, the easier it is for them to approve a mortgage loan because their risk is correspondingly lower.

The formula for DSCR is as follows:

DSCR = NOI / Total Debt Service

A DSCR of 1 or greater indicates that the property is producing enough net income to pay its mortgage debt payments. If the DSCR is less than 1, then the property is not producing enough net operating income to meet its mortgage debt payments. This situation indicates that the property has a negative cash flow. The result would be that the borrower would have to supply the shortfall (the amount of negative cash flow) out of his or her personal funds.

Example: If annual NOI = $10,000 and annual debt service = $11,000, what is the DSCR and its ramifications for the property owner?

DSCR = $10,000 / $11,000 = 0.91

The income produced by this property is only sufficient to pay 91% of the total debt service. The property owner would have to pay $1,000, or roughly 9% of the total annual debt service out of his or her own personal funds each year to make up for the negative cash flow.

Many commercial lenders require the DSCR to be 1.3 or higher (NOI / annual loan payments). This will ensure that a sufficient net income is available to cover loan payments on an ongoing basis. In this manner there will be less risk of foreclosure and increased security for the lender.

For more information about debt service coverage ratio, please visit The Landlord's Library book collection. It's a terrific, one-stop source for practical, comprehensive information on the entire subject of residential landlording.

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