Debt Service Coverage Ratio (D.S.C.R.) - The debt service coverage ratio, also referred to as the debt service ratio, measures the relationship between the amount of cash available to service the debt payments, which is the Net Operating Income, to the required debt payment to the lender.
This ratio is especially important to lenders. Their primary concern is your ability to service the outstanding debt, or in other words, your ability to make the payments. This ratio will vary among lenders, but a general range is from a minimum of 1.00 to a maximum of 1.35, with the most common ratio averaging about 1.20.
There are a number of factors that influence the lender's D.S.C.R. requirement including the age and condition of the property, the loan to value ratio, and your strength as a borrower.
While it is the lender who relies heavily on this ratio, it is equally important for you as the investor to understand its role in the financing equation. When you analyze a prospective property, you must be able to determine if there is adequate cash flow to service the debt. Without it, you'll never get a loan.
If the deal doesn't cash flow sufficiently to meet the D.S.C.R. requirements with a 20% to 30% down payment, chances are you'll want to take a pass on the deal and go on to the next one.
One final thought here. Please do not make the mistake of saying, "Oh, I'll just put more money down to lower my monthly payments." It is true, that would help to bring your D.S.C.R. in line, but guess what? By putting more money down, you are reducing the cash on cash returns, as well as the total R.O.I.s. An investor's primary goal is typically to maximize the return on investment, so the lower the initial equity and/or cash investment, the higher the R.O.I. will be.
As loans are amortized over a period of years, there are two parts of every payment - interest and principle. The payment amount can be 100% interest and 0% principle (as in an interest only term loan with a balloon), or it can be a more traditional loan repayment structure similar to what exists in residential loans with the amount of interest paid each month declining over time while the amount of the principle (the actual amount of the loan dollars borrowed) being repaid each month increases.
FYI - There are dynamic real estate investment software models that allow the user to see these ratios and their effects on cash flow by simply changing a few key variables.
Hope this helps!
Steve Berges - Author
Feb 5, 2011