I often get calls from aspiring investors that are looking to take advantage of the tremendous opportunity in the acquisition of multifamily real estate. When it comes to financing this type of real estate I thought it would be a good idea to revisit a topic that plays an important role in the loan process.
DSCR stands for Debt Service Coverage Ratio. When lenders review your project they calculate the ability of the property’s rental income to cover the proposed debt. So while an investor may consider an apartment building a great deal a lender may not think so if the DSCR is below the standard guideline (usually 1.20). As a matter of fact DSCR is the traditional way for a commercial property to qualify for financing.
So how do lenders determine the DSCR? There are two steps to the process.
1. NOI (Net Operating Income) is first being determined. So, here is the formula:
NOI = Total Rental Income – VC (Vacancy & Collections) – OE (Operating Expenses)
Generally the OE include Taxes, Insurance, Utilities, Repairs & Maintenance, Property management, and Reserves. While they do take in consideration the actual expenses provided by the seller, they often use their own formula roughly 40 – 50% of the gross income, and apply the more conservative figure. VC is typically a percentage (about 5%-10%) of the total income that is evaluated based on the history and condition of the building, and the area.
2. With a NOI figure next step is in determining the DSCR. Again, here is the formula:
DSCR = NOI/P&I
The NOI is based off of the total annual income and the P&I represent annual Principal & Interest payments projected on the new loan. The terms of the new loan are very important when qualifying the property for financing. The interest rate and amortization are key factors. In a moment I’ll show you why. But first let me show you how you can easily figure out whether your deal will is feasible when submitted for the lender’s evaluation.
In this example, let’s just say you’re working with an annual Gross Income of $150,000. You have no actual expenses from the seller.
Est. NOI = $150,000 X 50% (VC & OE) = $75,000
Next, let’s just say the PP (Purchase Price) is $800,000 and your DP (Down Payment) is $250,000. The financed amount would be $550,000. On a 15 yr. amortization with a 6% rate the monthly P&I payment would be $4,641 and the annual P&I is $55,692.
DSCR = $75,000/$55,692 = 1.347
In this case the property would debt service and the lender would most likely look at the transaction favorably. However, do not consider a favorable DSCR an indication of loan approval. Now, if the loan amortization is over 10 years instead of 15, even if the rate is lower than in the initial example, let’s say 5.5%, the property would not qualify.
DSCR = $75,000/$71,627 = 1.047
Finally, there are other factors that impact the transaction, as well. However, on the subject matter keep this in mind: 1) The DSCR must be at a minimum 1.20 no matter how good everything else looks and 2) The higher the ratio the better the deal and the easier to qualify.