There are a variety of metrics that real estate investors use to monitor the financial performance of a rental property. One of the most overlooked and misunderstood is the debt service coverage ratio in real estate.
Lenders calculate the debt service coverage ratio as part of the underwriting process. Real estate investors can adjust their offer on a rental property to produce a specific debt service coverage ratio, and also monitor the ratio to help tell if the time is right to refinance a rental property.
Key takeaways
- Debt service coverage ratio indicates the amount of net cash flow available to pay the mortgage.
- Both real estate investors and lenders use the debt service coverage ratio when analyzing rental property performance.
- Knowing how to calculate net operating income is key to accurately determining the debt service coverage ratio.
- Debt service coverage ratio can increase or decrease from year to year.
What is debt service coverage ratio in real estate?
Debt service coverage ratio – or DSCR – is a metric that measures the borrower’s ability to service or repay the annual debt service compared to the amount of net operating income (NOI) the property generates.
DSCR indicates whether or not a property is generating enough income to pay the mortgage. Lenders use the debt service coverage ratio as one measurement to determine the maximum loan amount when a real estate investor is applying for a new loan or refinancing an existing mortgage.
The larger the DSCR ratio is, the more net operating income there is available to service the debt.
How to calculate debt service coverage
The formula for calculating debt service coverage ratio is very straightforward. The DSCR for real estate is calculated by dividing the annual net operating income of the property (NOI) by the annual debt payment.
DSCR formula
- Debt Service Coverage Ratio = Net Operating Income / Debt Service
For example, if a rental property is generating an annual NOI of $6,500 and the annual mortgage payment is $4,700 (principal and interest), the debt service coverage ratio would be:
- DSCR = NOI / Debt Service
- $6,500 NOI / $4,700 Debt Service = 1.38
A DSCR of 1.38 means there is extra net operating income available than is needed to service the annual debt. On the other hand, a DSCR of 0.97 means that there is only enough net operating income available to pay for 97% of the annual debt payments.
Before we dig deeper into the debt service coverage ratio, let’s review what to include and exclude when determining net operating income for a rental property.
How to determine NOI
Understanding how to accurately calculate net operating income is important because NOI has a significant impact on the debt service coverage ratio, the mortgage loan amount an investor can obtain, and the amount of income available to service the debt.
An NOI that is artificially high will overstate the amount of income available to service the debt, while an NOI that is low due to a miscalculation will understate the amount of income that can be used to pay the mortgage.
NOI is calculated by deducting all necessary operating expenses from all income a property generates. To accurately determine the income from a rental property, add up all of the potential income, then subtract vacancy and credit losses:
- Gross Operating Income = Potential Rental Income – Vacancy Rates
For single-family rental homes and small multifamily properties, potential rental income includes the monthly rent a tenant pays, plus “extra” rental income like pet rent, utilities charged to a tenant (in a multifamily property), and appliance rent.
Potential rental income assumes the property is occupied 100% of the time. But that isn’t realistic, because most rental properties have periods of vacancy, such as when a vacant property is first purchased or the time in between tenant turns.
Some investors use a vacancy rate of 5-10% as a “ballpark” reduction, but randomly choosing a vacancy percentage can lead to a gross operating figure that is over or understated. There are a couple of good ways to understand what the true vacancy history of a rental property is.
One way to help forecast vacancy if records are not available is to consult with a local property manager who currently manages homes in the same neighborhood or area.
Once the gross operating income is calculated, the next step is to add up all of the necessary operating expenses for the property. Typical operating expenses for a single-family rental and small multifamily building include:
- Property management fees
- Repairs and maintenance
- Property taxes
- Insurance
- HOA fees
- Utilities (sometimes included as a landlord expense for a multifamily property)
Items excluded from necessary operating expenses include capital expenditures (CapEx), depreciation, and the debt service or mortgage payment.
These costs are not included when calculating operating expenses because they may vary from one investor to another. For example, one buyer may make a conservative down payment of 25% when financing a rental property, while another may use a high LTV by making a smaller down payment.
By subtracting necessary operating expenses from gross operating income, an investor can determine the net operating income of a rental property:
- Net Operating Income = Gross Operating Income – Operating Expenses
For example, if a single-family rental home generates an annual gross operating income of $12,500 and operating expenses are $6,000 per year, the net operating income would be $6,500:
- $12,500 Gross Operating Income – $6,000 Operating Expenses = $6,500 Net Operating Income
If an investor is applying for a mortgage and the annual debt service (principal and interest) is $4,700 the debt service coverage ratio would be:
- DSCR = NOI / Debt Service
- $6,500 NOI / $4,700 Debt Service = 1.38
Based on this example, the home is generating more net operating income than is needed to pay for the annual debt.
How real estate investors use DSCR
Let’s assume an investor is thinking about purchasing a rental property with an asking price of $150,000.
Prior to making an offer, the investor connected with a lender partnerand learned that the lender will require a DSCR of 1.40.
If the property is generating an NOI of $7,500, the investor can use the DSCR formula to calculate the amount of annual debt service the lender will allow, and the down payment needed to purchase the property.
The first step is to rearrange the debt service coverage ratio formula to calculate the maximum allowable mortgage payment:
- DSCR = NOI / Debt Service
- Debt Service = NOI / DSCR
- $7,500 NOI / 1.40 DSCR = $5,357 Debt Service (principal and interest)
After consulting with the lender, the investor learns a down payment of 30% will be needed to purchase the rental property at the asking price in order to meet the lender’s requirement for a DSCR of 1.40.
An investor can utilize the DSCR formula when shopping around in some of the best markets for rental property.
For example, assume an investor has set aside $25,000 in capital to be used as a down payment, and the lender requires a debt service coverage ratio of 1.35. The investor can now look for rental homes for sale across the country that meet the investor’s down payment allocation and the lender’s DSCR requirements.
Is there a good debt service coverage ratio in real estate?
While there’s no industry standard of a good debt service coverage ratio in real estate, many lenders and conservative real estate investors will look for a DSCR of at least 1.25.
That means there is more net cash flow than is needed to meet the annual principal and interest payments of the mortgage, after all of the normal operating expenses have been paid.
The lower the DSCR is, the greater the risk that an investor may have to go out of pocket to pay the mortgage if the property is vacant for an extended period of time or operating expenses are higher than expected.
Why DSCR changes over time
The debt service coverage ratio of a rental property can and will change after an investor has purchased the home.
That’s because the numerator or the NOI can increase or decrease from year to year, while the denominator of the amount of annual debt service generally stays the same, assuming the mortgage on the rental property is at a fixed interest rate.
To illustrate, suppose an investor forecasts that the NOI of a rental home will grow by 3% per year. Over a five-year holding period, the change in DSCR might look something like this:
| Year | NOI | Debt Service | DSCR |
| 1 | $6,500 | $4,700 | 1.38 |
| 2 | $6,695 | $4,700 | 1.42 |
| 3 | $6,896 | $4,700 | 1.47 |
| 4 | $7,103 | $4,700 | 1.51 |
| 5 | $7,316 | $4,700 | 1.56 |
Of course, the DSCR could also decrease over time if the rental property doesn’t perform as anticipated. If tenant turnover is higher than expected, perhaps due to a poor tenant screening process or an inexperienced property manager, NOI could go down from one year to the next.
Closing Thoughts
An increasing debt service coverage ratio could be a sign that the time is right to refinance a rental property. That’s because a larger DSCR indicates that there is a growing amount of net income available to service the debt.
Real estate investors who use Stessa to automatically track income and expenses can tell at a glance how much net operating income a rental property is generating, while the Stessa Balance Sheet periodically adjusts the market value of the property to monitor equity in almost real-time.
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