Multifamily investment term #2: debt service coverage ratio

We recently wrote about net operating income (NOI), which is the cash that remains after accounting for all revenues and expenses related to a property's operations. Note loan payments are not considered operating expenses; they do not contribute to the expenses that are used to determine NOI.

However, loan payments are used to determine a property's debt service coverage ratio (DSCR). The debt service coverage ratio is a ratio that measures the cash that is available after all loan payments are taken into account. In other words:

DSCR = (Net Operating Income)/(Annual Loan Payments)

The debt service coverage ratio is important because in addition to setting a maximum loan to value ratio, most lenders will require a minimum debt service coverage ratio before a loan can be issued.

For example, suppose a lender requires a minimum DSCR of 1.25.

Now suppose the annual net operating income for the subject property is $150,000, and the annual payments for the desired loan are $125,000.

DSCR = ($150,000)/($125,000) = 1.2

In this case the DSCR does not meet the lender's minimum requirements. The financed amount would need to be reduced in order to bring the annual loan payments down and the DSCR up to the lender's minimum standard of 1.25.

Soon we'll cover another important loan constraint - the loan to value ratio.

Dan Miller, Realtor, Certified Distressed Property Expert, Keller Williams Realty and DaneCountyMarket.com