Real Estate Investing
What is Debt Service Coverage Ratio and Why it’s Important?
There are few numbers more important in commercial real estate than the debt service coverage ratio.
It’s one of the first things and one of the last things that any commercial lender or broker will talk about. It’s first and last because it’s simply that important!
A lot of people toss this term around without explaining it while others are using it without fully understanding it. It’s a lot more than just a simple formula and when you understand the debt coverage ratio, you’ll be able to control it to get maximum financing.
Let’s dive into it.
Why the DSCR is Important
Imagine finding a commercial property worth $400,000 and you need to put 25% down.
You think, “alright, I can afford that!” and move forward with the deal, expecting $300,000 in loan proceeds.
As you approach closing, your mortgage lender calls you to say “The maximum loan we can give you is $225,000 because the debt coverage ratio is too low.”
Now what do you do?
This is real and happens every day. To avoid a situation like this, you need to fully understand the debt service coverage ratio before you make offers.
The fact is that it’s regularly used by banks and loan officers to determine if a loan should be made and what the maximum loan should be. If you don’t have the extra money laying around, you won’t be able to close the deal and you’ll lose a lot of money.
Debt Service Coverage Ratio Defined
The debt coverage ratio is a simple ratio that tells a lender how much of your cash flow is use to cover the mortgage payment. It’s known as the debt service coverage ratio, debt coverage ratio, DSCR, or DCR.
Debt Service Coverage Ratio Calculation
In general, it’s calculated as:
where:
Net Operating Income = Gross Income – Total Operating Costs
Debt Service = Principal + Interest
To calculate the debt coverage ratio of a property, first, you need to calculate the NOI. To do this, take the total income, subtract any vacancy, and also deduct all operating costs.
Remember, operating costs do not include debt service (principal and interest), or capital expenditures. Insurance and taxes are operating costs, so don’t forget to include them.
Next, take the Net Operating Income and divide it by the annual debt service, which is the sum of all principal and interest payments during the year.
To do this you must take the entity’s total income and deduct any vacancy amounts and all operating expenses. Then take the net operating income and divide it by the property’s annual debt service, which is the total amount of all interest and principal paid on all of the property’s loans throughout the year.
How The Debt Ratio is Used
A Debt Coverage Ratio below 1 means the property does not generate enough revenue to cover the debt service while a debt ratio over 1 means the property should, in theory, generate enough revenue to pay all debts.
It’s very common for lenders to require a 1.2 DSCR, give or take.
If your debt coverage ratio is too low, the only way to make it work out better is to reduce the loan balance. Your NOI is the same but now your principal an interest decreases, making the ratio go up.
And that’s how you can get your loan proceeds cut dramatically.
Debt Coverage Ratio Example
Let’s say there is a property that generates $10,000 in revenue, has total operating costs of $4,800, and yearly debt service of $4,000
NOI = $10,000 – $4,800 = $5,200
In this example, the debt coverage ratio is above 1.2, so this would be a good risk for the bank and they’d likely give the loan.
Let’s say that interest rates change and the bank gives a slightly higher rate, causing a new debt service of $4,500.
Notice how a small change can suddenly change everything!
The Bank Will Reduce Your Loan
In this situation, the bank probably won’t reject the loan. Instead, they will reduce the loan balance until the payment comes in line with their minimum DSCR requirements.
In this situation, the lender will simply reverse the formula and determine what the maximum debt service can be. We can plug in the variables we know to solve for the allowable debt service
1.2 = $5,200 / Max Debt Service
Max Debt Service = $5,200 / 1.2
So, the maximum debt service can be $4,333. Now they just need to figure out what loan balance that will be based on their interest rate and loan term.
…and you’ll be stuck trying to squeeze some quarters out of your couch to pay for the extra down payment.
How the Debt Ratio Affects Returns
In the example above I showed how a loan can be adjusted down before the lender will give the loan. This can significantly reduce your cash on cash returns.
Let’s say you are buying a property in the example above costs $100,000 and requires a down payment of $25,000.
Let’s also say that it generates $10,000 in cash each year and has an NOI of $5,200.
Originally the debt service was supposed to be $4,000 per year, leaving $1,200 in total cash flow.
Now, let’s calculate our cash on cash return. We know that it’s calculated as:
Cash on Cash Return = Total Cash Flow / Total Cash Invested
CoC = $1,200 / $25,000 = 4.8%
This means that for every $100 you invested, you get back $4.8 every year, cash in the bank. This is not to be confused with the overall return on investment.
But due to some fluke, the terms changed and now the debt service will increase. Let’s say that the interest rates increase so your $75,000 loan is at 4.5% now and your debt service goes up from $4,000 per year to roughly $4,560/year. You can see that the new debt service coverage ratio is well below the 1.2 minimum.
I’ll spare you the math, but when I punch it into a calculator I find that the maximum loan value is now roughly $71,000. This creates a yearly debt service of $4,320, bringing you back to 1.2
Comparing The Two Scenarios
Since you’re loan has gone down, you will need to invest an extra $4,000. You’ll also have a lower cash flow because of the higher debt service.
Cash Flow = $5,200 – $4,320 = 880.
Now let’s compare two scenarios. Imagine if you were still able to get 25% down, your cash on cash would look like:
CoC = $880 / $25,000 = 3.5%
Not very good, right? But, that’s because of the increased interest rates.
Now, let’s see how the change in the loan amount affects your return. Remember, your down payment is no longer $25k because it became $29k.
CoC = $880 / $29,000 = 3.03%
Even worse…
Never Neglect the Debt Coverage Ratio
You can see how important this simple ratio is to banks. It can change your returns, your down payment requirements, and it can even kill your deal.
This article originally appeared on IdealREI. Follow them on Facebook, Instagram and Twitter.
By Sheryl Chapman
As we all know, the economy can be unpredictable at times. Recession is a common phenomenon that can affect the investments in your portfolio.
But don’t worry, there are some sectors that are likely to perform well—even during a recession. Here are five recession-proof investments that you can consider adding to your portfolio.
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1. Consumer staples
Consumer staples are products that are essential to our daily lives, such as food, household goods, and personal care items.
These products are in constant demand, regardless of the economic climate. Companies that produce these items, such as Procter & Gamble and Coca-Cola, are considered recession-proof investments.
These companies have a stable revenue stream that can weather economic downturns.
2. Utilities
Utilities are another recession-resistant investment. People need electricity, gas, and water, regardless of the state of the economy.
Utility companies, such as Duke Energy and American Electric Power, have a steady stream of revenue and provide investors with a reliable source of income.
3. Healthcare
The healthcare industry is recession-proof because it provides essential services that people cannot do without. Companies that provide healthcare services or products, such as Johnson & Johnson and UnitedHealth Group, are likely to remain profitable during a recession.
4. Gold
Gold is a safe-haven investment that many investors turn to during times of economic uncertainty. Gold prices tend to rise during recessions because it is seen as a store of value. Investors can buy physical gold, gold ETFs, or invest in gold mining stocks.
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5. Treasury bonds
Treasury bonds are considered to be one of the safest investments during a recession.
These bonds are issued by the US government and are backed by the full faith and credit of the government. Treasury bonds provide a fixed income and are considered to be a low-risk investment.
In conclusion, these five investments are considered to be recession-proof because they provide essential products or services that people cannot do without.
Adding these investments to your portfolio can provide stability during times of economic uncertainty.
Airbnb has revolutionized the travel industry by providing an affordable and unique way for travelers to experience different destinations.
With over 7 million listings worldwide, it’s safe to say that Airbnb has become one of the most popular ways for travelers to find lodging.
However, as a host, one of the most challenging decisions you’ll face is determining the right price for your listing.
Pricing your Airbnb listing correctly is critical to your success as a host, as it can make or break your profitability.
Here are some tips to help you price your Airbnb listing for maximum profit:
Know Your Market
Before you set your price, it’s essential to research the market in your area. Look at other listings in your neighborhood, paying attention to the size of the property, amenities, and location. Check the availability of your competitors and the average price they charge. This information will help you determine your pricing strategy and ensure that your listing is competitive.
Consider Seasonal Demand
Seasonal demand plays a significant role in the pricing of your Airbnb listing. During peak seasons, such as holidays, festivals, and major events, you can charge higher rates. Conversely, during low seasons, you’ll need to lower your prices to attract guests. Keep track of events happening in your area and adjust your prices accordingly.
Offer Discounts
Offering discounts is an effective way to attract guests and increase your occupancy rate. Consider offering discounts for extended stays, early bookings, or last-minute reservations. You can also offer discounts to guests who leave a positive review or refer new guests to your listing.
Calculate Your Costs
To ensure that your pricing strategy is profitable, you need to calculate your costs. Take into account expenses such as cleaning fees, utilities, maintenance, and taxes. Factor in your time and effort as well. Your goal is to set a price that will cover all your costs while still allowing you to make a profit.
Be Flexible
Finally, be flexible with your pricing strategy. Test different prices and see how they affect your occupancy rate and profitability. Monitor your competition regularly and adjust your prices accordingly. Remember that the market is constantly changing, and your pricing strategy needs to adapt to stay competitive.
In conclusion, pricing your Airbnb listing for maximum profit is a crucial aspect of your success as a host. By researching your market, considering seasonal demand, offering discounts, calculating your costs, and being flexible, you can set the right price for your listing and maximize your profitability.
Happy hosting!
Are you looking for a way to earn some extra cash? Have you considered turning your spare room into a money-making Airbnb business?
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1. Prepare Your Space: Before you start accepting guests, you need to make sure your space is guest-ready. This means cleaning thoroughly, providing fresh linens and towels, and decluttering the space.
PRO TIP: You may also want to consider adding personal touches like fresh flowers or a welcome basket to make guests feel at home.
Here’s a growth hack from the Airbnb lecture inside the academy: “A nice personal touch like a letter or a note can go a LONG way.”
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2. Create Your Listing: Once your space is ready, it’s time to create your Airbnb listing. (Here’s a guide on how to do this in 10 minutes. AND it pays you $25.)
This is where you’ll showcase your space and attract potential guests. Make sure to include high-quality photos, a detailed description of your space and amenities, and accurate pricing information.
You may also want to consider offering discounts for longer stays or adding extra perks like free breakfast or use of a pool.
3. Manage Your Guests: Once your listing is live, you’ll start receiving inquiries and bookings. It’s important to communicate promptly and clearly with guests to ensure a positive experience for everyone.
Make sure to answer any questions they may have and provide detailed check-in instructions.
During their stay, make sure to be available to address any issues that may arise and provide recommendations for local attractions and restaurants.
With these steps, you can turn your spare room into a profitable Airbnb listing and start earning extra income. Happy hosting!
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