To get a rental loan from a private lender like ABL, you must meet a minimum DSCR requirement. Having a high Debt Service Coverage Ratio (DSCR) not only protects the lender but ensures you can afford the loan, making it a key metric for gauging potential investments before you pursue them.
What Is DSCR?
DSCR stands for debt-service coverage ratio and measures how much cash flow is available to cover debt obligations. In real estate, it refers specifically to a property’s cash flow and its ability to cover the mortgage payments financing the property.
How to Calculate DSCR
To calculate DSCR, divide a property’s net operating income (NOI) by its total debt service (including principal and interest). Here’s the formula:
DSCR = Net Operating Income / Total Debt Service
For example, if a property generates an annual NOI of $30,000 and the annual mortgage costs total $25,000, the property would have a DSCR of 1.2 ($30,000 / $25,000).
Alternatively, you can calculate DSCR with the monthly NOI and mortgage payment. For example, the same property would have a monthly NOI of $2,500 ($30,000 / 12) and a monthly mortgage payment of about $2,083 ($25,000 / 12). Either way, the DSCR comes out to 1.2.
How DSCR Is Used
DSCR is a widely used indicator of a rental property’s financial health. Anything above a 1.0 DSCR means the property generates enough cash flow to cover its debt service, while anything below 1.0 means it doesn’t (aka negative cash flow).
Many real estate lenders set a minimum DSCR threshold for properties to clear before they will consider financing them. This way, they can control the amount of risk they take. The higher the DSCR, the more likely the borrower is to pay back the loan and the less risk to the lender.
However, some lenders are more strict than others. For example, ABL has an average DSCR requirement of 1.2 but also offers lower DSCR programs. We’ll tailor our rental loans to your unique situation and needs.
What Is a Good DSCR Ratio?
While there’s no universal DSCR standard, many lenders want to see a minimum DSCR of 1.25. This leaves some room in the monthly budget for capital expenditures (CapEx), vacancies, and other unexpected costs to ensure you can still pay the mortgage each month.
In contrast, a 1.0 DSCR is often cutting it too close. It means the property has just enough cash flow to cover its debt service, and any underperforming months will be cash flow negative. In such cases, the borrower must draw on other capital sources to pay the mortgage.
In the best-case scenarios, your DSCR will be 2.0 or higher. This means your property generates twice as much cash flow as it needs to cover its debt obligations (or more), allowing you and your lender to rest easy.
Factors Impacting DSCR
To understand what affects DSCR, take a closer look at each part of the DSCR equation:
Net operating income (NOI) is calculated by subtracting a property’s operating expenses from its rental revenue. As a result, any rent increase will raise the DSCR and vice versa (all else equal). Conversely, any increase in operating expenses—such as maintenance, insurance, or utility costs—will lower the DSCR (and vice versa).
At ABL, our local DSCR teams know what works best to increase DSCRs in your market. They can analyze your proposed investment and help you identify areas for improvement—whether that’s raising rent or working with a new vendor to lower operating costs.
Debt service refers to your investment property’s monthly mortgage payment. The lower it is, the higher your DSCR. However, you can’t easily change your payment once loan terms are set, so the best time to lock in a low payment is upfront.
At ABL, our loan experts can work with you to secure loan terms that benefit everyone. For example, we offer rental loans with rate locks, LTVs up to 80%, and fast closing times (30 days or less).
5 Ways to Improve Your Rental’s DSCR
Here are five levers you can pull to raise your DSCR:
1. Increase Rental Income
Raising the rent—especially if it’s below market value—is one of the easiest ways to improve your DSCR. If the rent is already at its maximum market rate, consider adding additional revenue streams such as laundry or storage facilities. Alternatively, you could make property improvements to justify a rent increase—though keep in mind that any short-term costs may offset the immediate benefits to your DSCR.
2. Lower Operating Expenses
There are many ways to lower operating expenses. Here are some ideas:
- Negotiate better service contracts with contractors
- Perform regular maintenance to minimize the need for costly repairs
- Invest in energy-efficient systems. For example, smart thermostats and motion sensor lights can conserve energy by automatically adjusting to your tenants’ needs.
3. Optimize Financing Terms
Changing your monthly mortgage payment after the fact isn’t challenging, and with a lender like ABL, refinancing can be easy! Depending on your loan, you may be able to lock in a lower mortgage payment by refinancing to a lower interest rate or extending the loan term.
Consider refinancing with ABL. We’ve helped many investors refinance into stable rental loans with favorable terms. It all starts with a conversation about your project.
4. Improve Occupancy Rates
Vacancies drag down your rental income, especially if they persist for long periods. However, you can minimize them by attracting and retaining reliable tenants. For example, you can set competitive rates, invest in effective marketing, and ensure you respond to maintenance requests and other tenant concerns quickly.
5. Leverage Tax Benefits
Take advantage of the many tax breaks available to rental owners. For example, you can write off property expenses, mortgage interest, and depreciation to lower your operating expenses. You can also conduct a 1031 exchange to defer capital gains taxes.
Pre-Qualify for a DSCR Loan From ABL
If you’re unsure what a property’s DSCR is or how it stacks up, ABL can help. Our local DSCR pros can help you analyze a deal and tell you what type of financing is available.
Ultimately, we’re here to help get your next project off the ground. Pre-qualify for a DSCR loan today with no obligation or impact on your credit!