here are many ratios to pay mind to when investing in real estate. Cap Rate and Cash on Cash Return are the two that get the most press, but there is another just as important and it’s vital when using financing.
The Importance of Debt Service Coverage Ratio
First – Debt Service Coverage Ratio (DSCR) is a ratio of income to principal and interest payments. Basically, it is a cash flow metric.
A DSC of 1 means that there is roughly equal amounts or money coming in and going out, breaking even if you will. A number greater than 1, such as 1.5, would mean that you have positive cash flow. While a number below 1 means the property has negative cash flow.
Calculating Debt Service Coverage Ratio
DSC = Net Operating Income (NOI) / Principal and Interest Payments
For example: Let’s say your net operating income is $9,500 for the year, while annual debt service is $7,500
The DSC is therefore $9,500 / $7,500 or 1.26.
You can also calculate this using monthly numbers if that is easier. Just take one month’s net operating income and divide it by your monthly mortgage payment.
The DSCR Mendoza Line
If you are not familiar with the Mendoza line, it is a baseball reference. The line is a batting average of .200 in the major leagues. You basically need to hit better than that if a player plans to stay in the league.
When it comes to the DSCR banks and lenders have a “Mendoza” line. That number is generally 1.25, but it does fluctuate. Some go as low as 1.2 while others want 1.3. During COVID, 1.3 and slightly higher became the norm, but that is already begin to relax back to industry standards.
Banks pick these numbers because they want a buffer on your ability to service your debt. If the DSCR is 1, then any hiccup means you may struggle to pay debt. There needs to be some cushion.
Purchase Loan or Refinance – Keep an eye on DSCR
Whether you are purchasing with a loan or plan to do a cash out refinance you need to pay mind to what this ratio will be when running the numbers.
When I’m calculating the cash out refi estimates on my BRRRR deals I’m looking at how much I can cash flow and if the DSCR will meet the required amount. If not, then I either need to keep money in the deal or restructure my costs.
Either way, the lender isn’t gonna lend if you don’t meet their required DSCR.
You can use the property calculator to derive your DSCR. If you need to learn how to run the numbers on a deal and come up with the DSCR then give the Investing in Rental Properties book. Or you can grab some coaching here.