Debt Service Coverage Ratio (DSCR) 

When evaluating an investment property, using rental metrics and analytics is crucial for making informed decisions. Metrics provide a clear picture of a property’s current or potential financial performance, helping investors gauge profitability and mitigate risks. Debt service coverage ratio is one metric that can help investors optimize their portfolios, ensuring they make the most out of their real estate ventures. 

What is Debt Service Coverage Ratio? 

Generally speaking, debt service coverage ratio (DSCR) is a financial metric that assesses a borrower’s ability to pay off their debts. In real estate, it measures how effectively a property’s net operating income (NOI) can cover its mortgage loan payments throughout the year (its debt service). 

Debt service coverage ratio is relevant to real estate investors because many lenders require a good DSCR to approve loans, as it indicates the borrower’s ability to meet debt obligations. A higher DSCR suggests that the property will generate more reliable cash flow, making it a safer investment for both the lender and investor. 

DSCR Formula 

The formula used to calculate DSCR is as follows: 

DSCR = (Net operating income / Total debt service) * 100

As you can see, DSCR is a simple ratio between net operating income (NOI) and total debt service. The top half of the formula, NOI, is the income a property will generate after regular, monthly expenses are subtracted, excluding variable expenses like maintenance, income taxes, and interest. NOI is calculated using the formula below: 

Net operating income (NOI) = Gross operating income (GOI) – Annual operating expenses

To find your NOI, simply take your gross operating income (your rental income minus any anticipated losses from vacancies) and subtract your annual operating expenses, those regular monthly costs of running the property. 

The bottom half of the formula, total debt service, is simply the amount of money you spend on your mortgage principal and interest payments over a year. 

When to Use DSCR 

DSCR is most useful when used in the evaluation stage of the real estate investment process. It can be used to determine if a property you’re considering buying will likely generate enough income to support the mortgage required to purchase it. DSCR can also be used before applying for financing to get an idea of whether a lender is likely to approve a certain size loan for a property. 

How to Use the Debt Service Coverage Ratio Calculator 

Using a debt service coverage ratio calculator or debt service coverage ratio Excel file can help you quickly determine whether a property you’re considering will cover its debt obligations. As part of a preliminary analysis, using the DSCR calculator can shorten and simplify your investment decision-making process by ruling out properties that clearly won’t be financially feasible. 

Let’s discuss how to use the debt service coverage ratio loan calculator for rental properties, including the inputs required and what you’ll get as the output. 

Inputs 

Here are the inputs you’ll need to use the DSCR calculator: 

1. Annual potential rental income 
2. Annual vacancy loss 
3. Annual operating expenses 
4. Mortgage payment (monthly) 

Annual potential rental income is the total income you expect to generate from a property over a year. This includes all the following types of income: 

• Rents 
• Nonrefundable deposits (e.g., nonrefundable pet deposits)
• Pet rent 
• Utilities
• Parking fees 
• Any other payments received for the use and/or occupation of a property 

Annual vacancy loss is the amount of income lost due to vacancies throughout the year. This value can be estimated by multiplying the monthly rental rate by the number of months the property is expected to lie vacant per year (or the weekly rate by number of weeks). 

Annual operating expenses is the sum of all non-variable, regular expenses you expect to incur from a property over the course of a year. Typical operating expenses include: 

• Property management fees (including software fees) 
• Advertising and listing fees 
• Landlord insurance premiums 
• Property taxes 
• Cleaning and maintenance fees 
• Supplies 
• Travel costs if you travel to your office/properties 
• Legal fees 
• HOA fees 
• Utilities you cover 

Lastly, your monthly mortgage payment should include both your principal and interest obligations each month. 

Outputs 

After you’ve entered each of the above values into the DSCR calculator, the following outputs will populate, including your final DSCR: 

• Gross operating income (GOI)
• Net operating income (NOI) 
• Total debt service
• DSCR 

Your gross operating income (GOI) is simply the amount of rental income you expect to actually collect in a year, accounting for any weeks or months your property lies vacant. 

Net operating income (NOI) subtracts your annual operating expenses to give you your actual take-home revenue before debt service. 

Debt service is simply your monthly mortgage payment times 12. 

Your debt service coverage ratio (DSCR) will appear as a number 0 or above and represents the ratio of your net income to your mortgage debt.  

How to Interpret Your DSCR 

What is a good DSCR? 

There are a few possible outcomes from the DSCR calculation: 

• A DSCR between 0 and 1 (e.g., 0.7) means that the property will not generate enough income to cover its mortgage. This suggests a high-risk investment for both lenders and investors. 

• A DSCR of 1 means the property generates exactly enough income to cover its mortgage, with no surplus. This is still a risky investment because it offers no cushion for unforeseen expenses. 

• A DSCR above 1 (e.g., 1.3, 2.3, or higher) indicates that the property generates more than enough income to cover its mortgage. The higher the better, as there is no upper limit to DSCR. High DSCRs indicate a strong ability to manage debt.  

According to Bankrate, a common minimum DSCR among lenders is 1.25, meaning that your property would have to generate enough income to cover at least 1.25 times its mortgage. However, each lender has their own standards and criteria. 

It’s important to remember that DSCR is just one of many financial ratios that could be used by lenders and investors to assess your ability to handle annual debt payments. However, by calculating your DSCR loan to income ratio, you’ll have a much better picture of your company’s financial health. 

Conclusion 

Debt service coverage ratio (DSCR) is a key tool for lenders and investors to assess a property’s financial strength and ability to handle debt. By using Innago’s debt service coverage ratio calculator, you can make more informed decisions about loan approvals and investment risks.