In this article, we will dive deeper into what is a good DSCR for rental property? and how it affects your investment.
Lenders use the debt service coverage ratio as one of the most essential metrics when evaluating rental property investments. (DSCR). The debt service coverage ratio (DSCR) contrasts a property’s net operating income (NOI) to its total debt service. Essentially, it determines if the rental income generated by the property is sufficient to support its expenditures, such as mortgage payments, property taxes, insurance, and maintenance costs.
What Is A Good DSCR For Rental Property?
A good DSCR for rental property varies depending on the type of property, location, and other factors. Generally speaking, lenders prefer a DSCR of at least 1.2, which means that the NOI is 20% higher than the total debt service. However, some lenders may require a higher DSCR, especially for riskier investments or properties located in volatile markets.
Understanding the Debt Service Coverage Ratio
Before we delve into what makes a good DSCR for rental properties, let’s first define what the ratio is and how it’s calculated.
As mentioned earlier, the DSCR is a measure of the cash flow available to pay off a property’s debt obligations. It’s calculated by dividing the NOI by the total debt service:
DSCR = NOI / Total Debt Service
The NOI is the amount of rental income generated by the property minus all operating expenses, except for the debt service. Operating expenses include property taxes, insurance, utilities, repairs, and maintenance costs.
The total debt service includes the principal and interest payments on the mortgage, as well as any other debt obligations related to the property.
For example, let’s say you own a rental property that generates $10,000 in monthly rental income. The operating expenses for the property, including taxes, insurance, and maintenance costs, add up to $3,000 per month. The monthly mortgage payment, including principal and interest, is $5,000. In this case, the NOI would be:
NOI = Rental income – Operating expenses = $10,000 – $3,000 = $7,000
The total debt service would be:
Total Debt Service = Monthly mortgage payment + Other debt obligations = $5,000 + $1,000 = $6,000
Therefore, the DSCR for this property would be:
DSCR = NOI / Total Debt Service = $7,000 / $6,000 = 1.16
A DSCR of 1.16 means that the property generates enough cash flow to cover its debt obligations, but with only a small margin of safety.
What Is Considered a Good DSCR for Rental Property?
As mentioned earlier, lenders generally prefer a DSCR of at least 1.2 for rental properties. This means that the NOI should be 20% higher than the total debt service. However, some lenders may require a higher DSCR, depending on the risk profile of the investment.
For example, if you’re buying a rental property in a high-risk market or with a high loan-to-value ratio, the lender may require a higher DSCR to offset the additional risk. In this case, a good DSCR could be as high as 1.5 or even 2.0.
On the other hand, if you’re buying a rental property in a low-risk market or with a low loan-to-value ratio, the lender may be more lenient with the DSCR requirements. In this case, a DSCR of 1.1 or 1.15 could be considered good enough.
It’s worth noting that a higher DSCR doesn’t necessarily mean that the investment is better. In fact, a very high DSCR could indicate that you’re leaving money on the table by not leveraging the property enough. This is because a high DSCR means that you’re generating more cash flow than you need to pay off your debt obligations.
On the other hand, a low DSCR could indicate that the property is overleveraged and that you may struggle to make your mortgage payments if rental income decreases or operating expenses increase. Therefore, it’s important to strike a balance between a good DSCR and a reasonable level of leverage.
Factors That Affect the DSCR for Rental Property
Now that we know what a good DSCR is for rental properties, let’s look at some factors that can affect the ratio:
The type of rental property you’re investing in can have a significant impact on the DSCR. For example, multi-family properties typically have a higher DSCR than single-family homes because the rental income is more diversified.
The location of the rental property can also have an impact on the DSCR. Properties located in high-demand areas with strong rental markets typically have a higher NOI, which can result in a higher DSCR. On the other hand, properties in lower-demand areas with weaker rental markets may struggle to reach a good DSCR, even with lower debt obligations.
The occupancy rates of the property can also affect the DSCR. A property with a high vacancy rate may struggle to generate enough rental income to cover its expenses, resulting in a lower DSCR.
The operating expenses of the property will also impact the DSCR. Properties with high operating expenses, such as older buildings that require more maintenance, may have a lower DSCR.
The terms of your loan can also affect the DSCR. For example, if you have a longer loan term, your monthly mortgage payments will be lower, which could result in a lower DSCR. Alternatively, shorter loan terms may lead to higher monthly payments and a higher DSCR.
Strategies for Improving the DSCR
If you’re struggling to achieve a good DSCR for your rental property, there are several strategies you can use to improve the ratio:
Increase Rental Income:
One of the most straightforward ways to improve your DSCR is to increase your rental income. This could include raising rents, offering additional services to tenants, or finding new revenue streams from the property.
Lower Operating Expenses:
Reducing your operating expenses can also help improve your DSCR. This could include negotiating better deals with vendors or investing in energy-efficient upgrades that lower utility costs.
Refinance Your Mortgage:
Refinancing your mortgage can help reduce your monthly payments and improve your DSCR. This strategy is particularly effective if you can secure a lower interest rate or a longer loan term.
Pay Down Debt:
Paying down your debt can also help improve your DSCR by reducing your total debt service. This could include making extra mortgage payments or paying off other debt obligations related to the property.
In summary, a good DSCR for rental properties is typically around 1.2, although this can vary depending on factors such as property type, location, and loan terms. While a higher DSCR is generally preferable, it’s important to strike a balance between a good DSCR and a reasonable level of leverage.
If you’re struggling to achieve a good DSCR for your rental property, there are several strategies you can use to improve the ratio, including increasing rental income, lowering operating expenses, refinancing your mortgage, and paying down debt.
Ultimately, the DSCR is an important metric that lenders use to evaluate your investment in rental properties. By understanding what makes a good DSCR and how to improve it, you can increase your chances of securing financing and achieving financial success as a rental property investor.