With a warming market and a stable passive income through the years, real estate investment has exploded in popularity. But many new investors are still learning the ropes: from how to choose new potential investments to getting the most from their returns. One important aspect of real estate investment is how to finance your properties. While your first property will likely be a traditional mortgage or a hard money loan, you can continually grow your portfolio with better loans by building up what’s called a DSCR— that is, a Debt-Service Coverage Ratio. Let’s take a closer look at what this metric is, how you can calculate it, and how you can use it to your advantage.
What is DSCR?
Debt-Service Coverage Ratio is a metric used by investors and lenders to determine how well rental properties can perform (or are performing). It’s an objective mathematical determination that shows whether you have a positive or negative cash flow.
DSCR looks at your property’s (potential) Net Operating Income and monthly and annual debts and expenses, coined as Debt Services.
Net Operating Income is how much money your rental property(ies) makes. This is generally in the form of rental income from tenants, long-term or short-term. Properties that count towards your NOI can be vacation rentals, Airbnbs, commercial properties, or rental residences such as single-family homes. Any rental property that you finance.
What Counts as Debt Services
The easiest way to think of debt services is PITIA: Principles, Interest, Taxes, Insurance, and Association Dues. This will include any current loans, property taxes, property insurance, homeowners association dues, etc. You can also include costs for running the property, such as utility expenses.
How to Calculate DSCR
To determine your DSCR, you want to divide your NOI by your Debt Services. This will give you a decimal number that generally falls between 0.0x and 2.0x. A DSCR of 2.0x can be considered ‘too good’ and calls for a closer look at how you are managing your finances and profits to assess risk.
What Counts as a Strong DSCR?
DSCR falls into three major categories: negative cash flow, neutral, and positive cash flow. A DSCR of 1.0x means that your properties make just enough money to pay their debts, but you make no profit. A DSCR below 1.0x means you are losing money and therefore have a negative cash flow. Anything above 1.0x indicates a profit or positive cash flow.
To make your DSCR work for you, aim for a minimum of 1.25x.
How to Strengthen Your DSCR
You can improve your numbers by either increasing your NOI or decreasing your Debts. There are a few ways to maximize your real estate income, one of which is to increase rent for your tenants, which may fall under restrictive state laws based on where your property is located. It can also cause tension between you and your tenants, so do so wisely and with great consideration.
The easier option is to decrease your debts. You can shop around for more affordable service providers, such as property management, but beware that more affordable doesn’t always have the same quality. You can also look at refinancing your mortgages or loans for lower principles and better interest rates.
It’s a balancing act between raising income and lowering expenses until you find the right combination to have a healthy DSCR and good business and tenant relationships.
How To Use DSCR to Further Your Investments
A strong DSCR allows you to take advantage of rental property-specific loans called DSCR Loans. Rather than looking into your personal income, DSCR loans look at your property management and potential property income. Most lender DSCR loan requirements include a DSCR of at least 1.25 and a minimum credit score of 640.
DSCR loans are specifically for rental investments— they cannot be used on primary residences. They have fewer restrictions than traditional loans and a faster underwriting process. They also have a higher loan-to-value ratio, meaning investors can expect to pay a 20-25% down payment on the property.
DSCR loans offer longer repayment terms, which helps reduce your monthly cost, but they do tend to have higher interest rates— a 1-2% increase.
Portfolio DSCR Loans
Some lenders offer what is called a portfolio DSCR loan. If you have multiple DSCR loans that have around $50,000 left on them, you can gather them all into one easy DSCR loan payment. Lender requirements will vary, so you will need to perform due diligence with potential lenders before applying. One fairly standard requirement is a credit score of at least 660.
Building Your Portfolio Through DSCR
Many investors take advantage of DSCR loans to steadily increase their properties. They can also be used to refinance rental properties, especially those purchased with hard money loans. This leads to a snowball effect: as you gain more properties, you recalculate your DSCR, and you reinvest your profit into more DSCR loans. Just be sure you have a stable cash reserve before you start reinvesting so you don’t overextend yourself.