DSCR for rental properties: what it is and what lenders want

The formula

DSCR = net operating income ÷ annual debt service. Net operating income, or NOI, is the rent you collect minus the costs of running the property: vacancy, property tax, insurance, maintenance, management and other costs. It leaves out the loan payments. Debt service is the loan payments for the year.

A worked example, using the starting figures in the Rental Property Analyzer:

• Rent, $2,200 a month × 12$26,400
• Less 5% vacancy$25,080 collected
• Tax $3,000 + insurance $1,400 + other $1,000− $5,400
• Maintenance 8% + management 8% of rent collected− $4,013
• Net operating income$15,667
• Loan payments for the year$12,000
• DSCR = $15,667 ÷ $12,0001.31

That is $1.31 of operating income for every $1.00 of loan payment. What is left after the loan, $3,667 a year, is the property's cash flow.

What the number tells you

• Below 1.0: the property does not earn enough to pay its loan. You would cover the gap from your own pocket every month.
• Exactly 1.0: the rent covers the loan and nothing else. One empty month or one repair puts you below it.
• Above 1.0: the cushion. At 1.31, the property's net operating income could fall by about 23% before it reached 1.0. That is the margin for vacancies, repairs and rate changes.

DSCR is not the same as cash flow. Cash flow is a dollar amount, and DSCR is a ratio, so a small property and a large one can have the same DSCR and very different monthly income. It is the better measure of how safe the loan is, and cash flow is the better measure of what you take home.

What happens when things move

The same property, changing one thing at a time from the example above:

• As above1.31
• Vacancy doubles, 5% to 10%1.21
• Insurance rises from $1,400 to $2,0001.26
• Loan payments rise 10%, to $13,2001.19
• Rent falls 10%, to $1,9801.13

A rent drop does the most damage, because the fixed costs stay where they are while the income shrinks. This is also why a property that looks comfortable at one ratio can be close to the line after a bad year. To see the occupancy at which the property stops covering its costs and its loan, use the break-even occupancy figure in the analyzer.

What lenders want

There is no single required DSCR. Fannie Mae's multifamily Near-Stabilization program, which lends on multifamily buildings, states a minimum underwritten DSCR of 1.25x at its "Tier 2" level, and 1.15x for mission-advancing housing loans. It defines underwritten DSCR as the ratio deemed achievable within four months after the rate is locked. That is one program for one kind of building, not a rule for every loan.

A loan on a single rented house or a small building usually comes from a different kind of lender, and each sets its own terms. Ask three things before you compare any ratio:

• Which rent do they use? The rent on your current lease, or the market rent from an appraiser.
• Which costs do they subtract? Your real expenses, a standard percentage of the rent, or none at all with the rent set against the whole monthly payment?
• Which payment do they count? Principal and interest only, or the full payment including tax and insurance?

The DSCR in this calculator is net operating income divided by the loan payments. A lender's number can come out higher or lower on the same property, so ask for the minimum and the method in writing before you rely on a ratio from any calculator.

How to raise it

1. Raise the income. Rent increases or lower vacancy lift net operating income directly.
2. Lower the running costs. Shop the insurance, and challenge the property tax assessment if the figure looks wrong.
3. Lower the loan payments. A larger down payment, a lower rate or a longer repayment term all reduce the annual payment.

Each of these has a cost somewhere else. A longer term lowers the payment and raises the total interest, and a bigger down payment ties up more of your cash. Run both versions before you pick one.

Mistakes to avoid

1. Using gross rent as income. A ratio built on rent before vacancy and costs looks better than the property really is.
2. Treating 1.0 as safe. It leaves no room for a single bad month.
3. Skipping maintenance and vacancy. Leaving them out is the quickest way to an optimistic number.
4. Assuming the lender will use your numbers. They apply their own method, so the ratio you work out and the one they work out can differ.