If you’re looking into investing into commercial property or residential real estate, on e of the things you’ll have to be familiar with is the debt service coverage ratio, or DSCR. It’s basically the net income of the property divided by the debt service, which gives you a ratio that lenders can use to determine how much of a risk you are to lend to.
For example, someone with a property with a net income of $130,000 and yearly debt payments of $100,000 has a DSCR of 1.3. That’s a very good ratio.
A Good Debt Service Coverage Ratio
In general, a good debt service coverage ratio is between 1.15 and 1.35, though many banks require a minimum of 1.25 on any purchase. What your bank can vary quite a bit depending on what your personal or business finances are like.
How can you improve your DSCR? There are several things you can do. First, you can reduce the amount of debt you owe on the property. Second you can increase your net income by raising rents or decreasing expenses. You may also be able to negotiate a better interest rate which could improve the ratio as well.
Take a property that currently has a net income of $100k and a debt service of $100k. If you raise your rents by 10% and generate an additional $10k of net income, then your new total is $110k. Likewise, you could find a new way to save money on your debt and save $10k per month, lowering your debt expense to $90k. You new DSCR would be $110k / $90k = 1.22, which is a lot better than where you started from.
Why do the banks care about DSCR?
For banks, what they’re trying to verify is that you’ll have enough money every month to pay the mortgage. If the ratio gets too close to 1.0, then there’s a danger that you won’t be able to pay the debt if you don’t have other income that can fill in when times get tough. What happens during recessions sometimes is that rents drop or vacancies increase, leading to a drop in net income (which in turns lowers your debt service coverage ratio). If the banks didn’t get the cushion up front to start and a recession happened soon afterwards, there would be a danger of the ratio falling below 1.0.