Of all the metrics used in underwriting multifamily assets, it is arguable that Debt Service Coverage Ration (DSCR) is the most important. Why? Aside from lenders having a minimum required DSCR, it keeps the operator and his or her investors out of trouble by measuring the ability for the property’s income to cover its debt service.
❓What is DSCR?
Debt Service Coverage Ratio (DSCR) is the ratio of a property’s annual net operating income to the annual debt service. Calculated by providing annual NOI by Debt Service. Lenders have minimum DSCR standards; ideal ratio is greater than 1.25. Any ratio greater than 1 means that the income exceeds the debt service.
As a simple example, if a property produces an annual income of $100,000, and the operator’s debt service is $75,000 annually, the DSCR is 1.33. In a different example, let’s say the property’s annual income is $75,000 and the debt service is $100,000. In this case the DSCR is .75. Much different from the first situation, this is a problematic position in that the property income does not sufficiently cover the debt service used to acquire the asset.
Finally, while lenders have requirements for DSCR, it is wise to well-exceed the minimum requirement. This ensures that the property income more that covers the investor’s obligations and there is margin in the business plan for uncertainty that could create hardship and negatively impact rental income.
💡The First Goal Of Investing
In The Two Goals of Money Management we shared that the investor’s first objective is to protect the principle. Measuring DSCR is a means of ensuring this goal. If a syndicator buys an asset that does not produce sufficient income to cover its debt service, it is a negatively cash flowing property, meaning that it is costing the operator money each month. This is a tough spot to be in when capital is needed to raise net operating income, make physical improvements and eventually sell for a profit. Lenders know the risk of barely covering the debt service and this is why they have the requirements in place.
