The most important ratio
to understand when making income property
loans is the debt service coverage ratio.
It equals Net Operating Income (NOI) divided
by Total Debt Service. To understand the
ratio it is first necessary to understand
the numerator and the denominator. Let's
take a look at net operating income (NOI)
first.
Net operating income is the income
from a rental property left over after paying
all of the operating expenses:
Gross Scheduled Rent = $100,000
Less 5% Vacancy & Collection Loss = $5,000
Effective Gross Income: $95,000
Less Operating Expenses
Real Estate Taxes
Insurance
Repairs & Maintenance
Utilities
Management
Reserves for Replacement Total
Operating Expenses: $35,000 Net
Operating Income (NOI) $60,000 |
Please note that lenders
always insist on some sort of vacancy factor
regardless of the actual vacancy rate in
an area to cover collection loss. In addition
lenders always insist on using a management
factor of 3-6% of effective gross income,
even if the property is owner-managed. Their
logic is that they would have to pay for
management if they took back the property.
Finally, NOTE THAT WE HAVE NOT INCLUDED
LOAN PAYMENTS AS AN OPERATING EXPENSE.
Next let's look at the
denominator, Total Debt Service. This includes
the principal and interest payments of all
loans on the property, not just the first
mortgage. NOTE THAT WE HAVE NOT INCLUDED
TAXES AND INSURANCE. They were already accounted
for above when we arrived at net operating
income (NOI).
To calculate the debt service
coverage ratio, simply divide the net operating
income (NOI) by the mortgage payment(s).
For the sake of simplicity, let us assume
that there is only one mortgage on the property:
$500,000 First Mortgage
7.5% Interest, 25 years amortized
Annual Payment (Debt Service) = $44,339 |
DSCR = Net Operating Income (NOI) = $60,000
Total Debt Service $44,339 DSCR
= 1.35 |
Obviously the higher
the DSCR, the more net operating income
is available to service the debt. From a
lender's viewpoint it should be clear that
they want as high a DSCR as possible.
The borrower, on the other
hand, wants as large a loan as possible.
The larger the loan, the higher the debt
service (mortgage payments). If the net
operating income stays the same, and the
loan size and therefore the debt service
increases, then the lower the DSCR will
be.
Life insurance companies
are very conservative and generally require
a 1.25 or 1.35 DSCR. This means that their
loan-to-value ratios are low. Savings and
loans (S&L's) generally only require a 1.20
DSCR, and sometimes will accept a DSCR as
low as 1.10.
A DSCR of 1.0 is called
a break even cash flow. That is because
the net operating income (NOI) is just enough
to cover the mortgage payments (debt service).
A DSCR of less than 1.0
would be a situation where there would actually
be a negative cash flow. A DSCR of say .95
would mean that there is only enough net
operating income (NOI) to cover 95% of the
mortgage payment. This would mean that the
borrower would have to come up with cash
out of his personal budget every month to
keep the project afloat.
Generally lenders frown
on a negative cash flow. Some lenders will
allow a negative cash flow if the loan-to-value
ratio is less than around 65%, the borrower
has strong outside income such as an electronic
engineer, and the size of the negative is
small. Lenders rarely allow negative cash
flows on loans over $200,000. |