Debt Coverage Ratio (DCR) Lenders want this

Real estate investors rarely grow their portfolios with all cash out of pocket. Leverage is not a bad thing, and proper use of leverage and other people’s money is a valued tool for real estate investing. This is particularly true and almost always necessary in larger multi-family or commercial rental property purchases.

When an investor or group of investors approaches a lender for a loan to finance a large property, they will be asking for a large amount of money, perhaps into the millions of dollars. Lenders will want a lot of information. Unlike a residential mortgage, the lender is looking at things other than the credit scores of the borrowers. The property becomes the major focus of scrutiny, as it’s the property generating the money to pay off the debt, not the salaries or other income of the investors.

There are dozens of income and expense ratios and financial statements to be examined in detail. The lender will want to be assured that the property’s expenses and income are as stated in financials, and that the net income from rentals will remain the same or increase in the future. One of the ratios the lender will use in evaluating the loan application is the DCR, Debt Coverage Ratio.

The DCR is the ratio between the net operating income (NOI) generated by the property and the annual debt service (ADS).

• NOI, Net Operating Income, is the income from rents less any and all expenses and taxes involved in ownership and management. It’s the “profit” in the ownership of the property.
• ADS, Annual Debt Service, is the mortgage payment.

The DCR is calculated by dividing the Net Operating Income by the Annual Debt Service. So, by way of example, if a property generates $180,000 in annual net operating income, and the mortgage payments are $15,000 per month, then the DCR is 1.00, or $180,000 / $180,000 ($15,000 x 12).

The lender sees that this property only generates just enough money after expenses to pay the mortgage. Most lenders will require at least a 1.20 DCR, as they will want some cushion to make sure that the mortgage will be paid if income falls or expenses rise.Clark