Debt Coverage Ratio (DCR) is one of those terms associated with real estate investing we may routinely hear enough to become familiar with, yet not have a clue about its significance or how to interpret it correctly.
Fair enough.
So in this article, we’re going to discuss debt coverage ratio so those of you engaged in real estate investing will at least have a general understanding about what it is and how to calculate it. We are also providing an example with three scenarios in order to show you how to interpret the results.
What is DCR?
Debt coverage ratio is the ratio of cash available for debt servicing to interest, principal and lease payments primarily used by lenders as a benchmark to measure an investor’s ability to produce enough cash to cover the debt (including lease) payments when the investor is financing or refinancing a particular rental property.
In a nutshell, DCR provides lenders with information that help them determine whether the rental property generates enough cash flow to cover its mortgage payment.
How to Calculate
The computation is fairly straightforward, but we should say something about net operating income (NOI) before we get to it.
NOI is the amount of property cash flow after being reduced by vacancy and credit loss and all operating expenses in a given year. Furthermore, an operating expense is one required to maintain and keep the rental property in service (i.e., producing an income). Loan payments, depreciation and other consideration of income taxes, and capital expenditures are not considered operating expenses.
Income
– Operating expenses
= Net operating income
Formulation
Net Operating Income / Debt Service = Debt Coverage Ratio
Example
Let’s assume a borrower is requesting a mortgage on an real estate investment property that generates a net operating income of $50,000.
Because we want to arrive at three different results to interpret next, we will provide three separate scenarios in which the NOI remains the same (i.e., $50,000) but with three different mortgage payments.
- Mortgage payment of $40,000: $50,000 / 40,000 = 1.25
- Mortgage payment of $50,000: $50,000 / 50,000 = 1.00
- Mortgage payment $55,500: $50,000 / 55,500 = 0.90
Interpretation
Okay, now let’s see how a lender would interpret the debt coverage ratio we computed for each of those three scenarios.
- 1.25: This indicates that there are more than enough funds to cover the debt service. In fact, there are 10,000 more dollars (25% more) than the payment requires. This is a good thing.
- 1.00: This indicates that there are just enough funds to cover the debt service but nothing would be left over for any margin of error. This is typically not good enough.
- 0.90: This indicates that there are not enough funds to cover the debt service and would require the owner to make up the difference “out-of-pocket.” This is absolutely not good enough.
Here’s the idea.
As a quick point of reference just remember that 1.0 is break-even. Therefore the higher this ratio is, the easier it is to obtain a loan. Likewise, a ratio that’s lower means less than enough to cover the mortgage payment and therefore it becomes more difficult to obtain a loan.
Naturally what ratio a lender is willing to accept is up to the lender, but don’t be surprised to find that most look for a DCR of at least 1.20.
So You Know
ProAPOD Real Estate Investing Software solutions automatically compute debt coverage ratio and then populate the appropriate reports. The computation is also available in ProAPOD’s iCalculator – a totally online real estate calculator that calculates and shows the formulas.
