Debt to rental income ratio?

Question

Is there a "rule of thumb" regarding a ratio of income you should get from a rental property versus how much a mortgage payment is on that property.  Obviously you are in it to make money, but is there a criteria that landlords try to live by if they don't have outright cash to purchase.

Patrick Liska · Answer

@Maria Marrero  Dept Service Coverage Ratio or DSCR for short, is the amount of Net Operating Income ( NOI ), which does not include your mortgage, Divided by Total Dept Service (TDS) ( usually mortgage payments, equity loans ) so the formula is: DSCR=NOI/TDS. If the calculation is equal to 1 then you are not making money, 1 represents that you have enough cash flow to cover your dept. less than one means you were not making money and greater than one means you have a cushion and making money. banks look for above 1 because they want to make sure you will be making enough money to pay them back and that you will have the money should costs rise and change your NOI, I know my bank looks for 1.25 DSCR . usually they just do not look at the properties, they will look at your personal situation ( credit card dept, alimony payments, medical payments) especially if they want you to personally back up the loan. there are a lot of explanations and probably better than i explained, all you have to do is look up DSCR, hope that helps.

Cara Lonsdale · Answer

1.25% debt service ratio is often used for commercial lenders.  This formula is used most frequently in a commercial property (5+ units) because often times the loan is a non-recourse loan ($1mm+) so the lender has to rely on the property to support itself since the lender can't look at the borrower as a qualifyer.

However, if you are talking about SFR or a 1-4 unit property, you can obtain a conventional loan.  While a 1.25% debt service ratio would be great, it wouldn't be required necessarily as the lender would be looking at you as the borrower as well.  The lender will take 75% of the established rental income from the property to qualify YOU for the loan.  if that 75% covers the mortgage payment (PITI) then the lender will fund on it with very little consideration for your finances.  IF the 75% falls short of the mortgage payment, then the lender will look at your financials to "help" the property pay for itself.

So, what does that mean to you?  IF you have little to no income to qualify for a loan, then you will need to seek out properties that already have established tenants paying rental rates that will support the PITI payment figuring 75% of that rental rate.  THIS CAN BE DONE!  I once had a client who was a home maker with a part time job making $18K per year that we found a SFR with a tenant in place to work for her purchase.  She was able to purchase the property because the 75% of the rental rate covered the PITI, so her personal income was of little consideration.

Good luck to you!

Troy Zsofka · Answer

I think that @Cara Lonsdale hit the nail pretty close to the head on this one.

From my experience, for a residential (1-4 unit) loan, the bank is going to use standard underwriting practices including DTI (unless they are going to portfolio the loan, in which case looking at DSCR would be the wisest choice in my opinion).

However, just to clarify a bit:

My experience is that they are going to do a personal DTI, not a property-only DTI (again, unless they portfolio, in which case they can do whatever they want). In other words, they are going to take 75% of each rental property's rental income, subtract the PITI payment from that, and then add what's left to your income (or to your debt if it's negative). Then, once each rental is done this way and applied to income or debt, they are going calculate your DTI and qualify or deny you based on the DTI requirements of that particular loan program (28%, 30%, 35%, 40%, 60+% back in 2005, whatever).

The above underwriting method is know as "washing" the debt of each rental property with its income.

Another way that they do it is they simply take the PITI of each property straight to the debt, and the rental income from each property straight to the income (usually also reduced to 75%); rather than washing it first.

It is advantageous to the borrower's qualifications to "wash" the PITI with the rental income and then apply the remainder, whether positive or negative, to income or debt.

To see why:

Let's say the property in question (loan subject property or not) rents for $1K/month and the PITI is $700/month. $750 (75% of rent) minus $700 equals $50 added to your income; thereby moving DTI in your favor.

On the other hand, let's say that the $750 is added to income, but the $700 to debt. The DTI for this portion alone equals 93.33% which moves the global DTI against your favor. In fact, even if they don't reduce the income and give you the whole $1K, it still results in a 70% DTI which still moves you in the wrong direction.

So, if your qualifications are tight, but your properties cash flow, find a bank that washes PITI with a portion of rental income before applying it to DTI.

Happy Investing,

Troy

Antoine Martel · Answer

Debt to income ratio should be around 1.2.

Which means the NOI should be 1.2X of the debt. Make sense?

Miguel Nava · Answer

Great job explaining that Troy! Thank you very much. I didn't know about the "washing" method, I assumed all lenders used the other one. Do you happen to know any specific lenders that actually wash the PITI for their DTI qualifications?

Miguel

Troy Schwamberger · Answer

Thanks again guys! Very good info. I appreciate it. Just getting started and it is more complicated yet more interesting the more I learn.

Antoine Martel · Answer

I know. and I think that that ratio is a good starting point. If he ever wants to get financed he should keep this number in mind as a bare minimum.

Steve Babiak · Answer

@Patrick Liska did a good job explaining DSCR, and the higher your DSCR the easier getting a bank loan becomes. There is another factor though that affects this sort of analysis - the amount of down payment (or equity above appraised value), along with LTV. A bigger down payment can lower the amount of the principal and interest being paid, so that DSCR can be met more readily - but that might not make that rental more attractive to an investor who is looking to have as little into the property as possible. Plus different lenders have different LTV - as low as 70% is not unheard of, I know of a portfolio lender who will go to 80%, and if somebody is getting conventional financing they could go to some higher LTV in some cases.

Corby Goade · Answer

I'm with @Anthony Dooley here. You need to decide what criteria works for you and your situation- in my mind, that is the most critical factor for success. There are some measures that don't take the debt service in to account, as mentioned above. Other than making your investment look good on paper, I can't see how that serves the investor in reality. The reality is that the debt service is money that leaves your pocket and goes to the bank, so that is money that you don't get to keep. In my mind, you HAVE to take that in to account.

To answer your question directly, for a quick analysis to see if I should dig deeper in to a deal, I use the 1% rule. Could I rent this place each month for 1% or more of the purchase price? If I think I could, I dig deeper, if I can't, I move on.

Patrick Liska · Answer

@Troy Schwamberger you are correct. the 1.2x is a bank standard for lending, even if you are at 1 and not bringing home money, you essentially are making money. your tenants are paying for the house ( adding equity) the bills are all being paid for to run the property, pay insurance and taxes. you also get to depreciate the property and if you do any improvements to the property or repairs that gets deducted or depreciated while adding to the basis of the property, if it is a capitol improvement.

Debt to rental income ratio?

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