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Why Debt Coverage Ratio is important
Also known as Debt Service Coverage Ratio (DSCR). The debt
coverage ratio is a widely used benchmark which measures an
income producing property's ability to cover the monthly mortgage
payments. The DCR is calculated by dividing the net operating income (NOI)
by a property's annual debt service. Annual debt service equals the
annual total of all interest and principal paid for all loans on a
property. A debt coverage ratio of less than 1 indicates that the
income generated by a property is insufficient to cover the
mortgage payments and operating expenses. For example, a DCR of .9
indicates a negative income. There is only enough
income available after paying operating expenses to pay 90% of the
annual mortgage payments or debt service. A property with a DCR of 1.25
generates 1.25 times as much annual income as the annual debt service
on the property. In this example, the property creates 25% more income
(NOI) than is required to cover the annual debt service.
Example: We are
considering buying an investment property with a net operating income of
$25,000 and annual debt service of $32,500. The DCR for this
property would be equal to 1.3. This means that it generates 30% more
annual net operating income than is required to cover the annual
mortgage payment amount. Many lending institutions require a minimum
debt coverage ratio value to procure a loan for income producing
properties. DCR requirements for lending institutions may vary from as
low as 1.1 to as high as 1.35. From a lending
institutions perspective, the higher the debt coverage ratio value, the
more income there is available to cover the debt service and thus the
less the risk.
Net Operating Income
(NOI) includes gross rents + other income, less vacancy amount and
operating expenses. Operating Expenses include the following items;
advertising, insurance, maintenance, property taxes, property
management, repairs, supplies, etc.
Lenders use the debt
coverage ratio to determine if an income producing property has
sufficient income to cover the operating expenses and debt service. To
acquire a loan for an income producing property, the debt coverage ratio
must usually be greater than 1.1 and most lenders require a debt service
coverage ratio greater than 1.2.
Tax laws,
regulations and rules change frequently. Accordingly, this information
is not intended to serve as legal, accounting, or tax advice. Larry
Albright is a Commercial Broker for Monument Commercial Real Estate in
Grand Junction and can be reached at 970-683-1030 or by email at larry@monumentcountry.com. |
