I don’t mean to always be contrarian, though most of the time I end up being exactly that — and my thoughts related to DSCR are no exception to that rule.

Debt Service Coverage Ratio (DSCR) is one of the measurements in the world of real estate investing that most investors pay very little attention to, while to me, it is one of the most important! Incidentally, it also happens to be the most important metric to the financiers, whether it be institutional or private.

## What Exactly is NOI?

Most people tend to judge the book by its cover, so to speak, and relative to DSCR, the classical definition is that this metric juxtaposes the Net Operating Income (NOI) to the debt service (mortgage payments). But first, let’s take a step back:

Question: What is NOI?

Answer: NOI is what is left of the Gross Yield (Gross Income) of an income-producing asset after all Operating Costs. Important to understand is that the Operating Costs do not include debt service. Thus, the formula for NOI is:

NOI = Yield – Operating Costs

Related: The 3 Metrics You Need to Know When Looking to Sell Your Investment Property

### What About the Mortgage Payment?

Well, if you paid all cash, then there is no mortgage payment. And if you financed any portion of the purchase price, then the mortgage payment needs to come out of the NOI.

## What Is DSCR?

DSCR identifies the relationship of the total amount available for debt service, which is NOI, with the actual amount of debt service resulting from your financing. For example, if the NOI on a building is \$1,000/month and the combined monthly debt service (monthly mortgage payments) are also \$1,000, then the DSCR is 1.0:

DSCR = NOI / Debt Service = \$1,000 / \$1,000 = 1.0

### What Does This Mean?

Well, in plain English, this means that after you pay the mortgage payment of \$1,000, there is going to be nothing left. This in turn means 2 things:

1. If the reason you are looking at this building is because of anything to do with Cash Flow, then there’s no reason to look at it any longer — there’s no CF, unless you manage to finance this thing a whole lot cheaper or put more money down. Doing that last thing is a big NO-NO, seeing as only idiots “buy” cash, and you are not an idiot — at least I hope not! But more importantly:
2. The banks will never go for it. They want you to be SAFE, and being on the bubble like this is anything but being safe. The banks know that should one thing go wrong, you’ll be in default. Someone smart once told me – if it’s not good enough for the bank, it shouldn’t be good enough for you.

### Why Does DSCR Matter to Me?

DSCR is a safety metric. DSCR tells us how easily we’ll be able to cover our debt obligations, and since the first rule of REI should be to avoid losing money, DSCR should be at the top of anyone’s analysis.

### What Is a Good DCSR?

For the banks, in today’s marketplace, a good DSCR seems to be around 1.25, which means that the NOI is 25% greater that the debt payments. For example, if your total debt service is \$1,000, the NOI must be no less than \$1,250. The lenders seem to agree that this is good enough today from what I see out there.

Related: The One Metric Far More Important Than Cap Rate or ROI for Real Estate Investors

However, I like to be even safer than that and will not take action on less than 1.4 DSCR.

## Conclusion

We talk about CCR, Cap Rates, and IRR all day long. But it seems to me that unless we can safely hold onto the asset for long enough, we risk much more than simply not realizing projected returns. Indeed, we risk losing our shirts!

DSCR should be paramount to your decision-making process relative to pulling the trigger on an income-producing investment!

Ben Leybovich has been investing in multifamily real estate since 2006. His area of expertise is creative finance. Ben works extensively with private as well as institutional financing. Ben the author of the Cash Flow Freedom University and creator of a cash flow analysis software CFFU Cash Flow Analyzer.

1. Great article Ben. Quick ask for clarification though.

You state that the mortgage payment should come out of NOI but I thought NOI was always used without debt service included so you could easily compare assets. If you subtract debt service you really have cashflow, not NOI, correct?

Also, for DSCR it feels like you are double counting debt service into the equation (noi – debt service)/debt service.

Thanks for any clarification/thoughts!
Brian

2. NO – I am sorry if I wasn’t clear. NOI – Debt Service = CF

This is why to establish the DSCR we use the NOI as the basis. NOI / Dent Service = DSCR

The question answered is – how much higher than the amount of debt service is the NOI…

Sorry for not being clear, Brian 🙁

• perfect. that makes sense. Thanks for the quick reply Ben.

I totally agree with DSCR being a strong indicator on performance. 1.4 seems to be the right level to shoot for (1.25 usually results in slim margin of error).

Thanks!
b

3. Ben, I coincidentally listened to your argument… I mean podcast #61 with Josh and Brandon last weekend where you also mentioned the point that putting more down to get CF is like buying money. It’s obvious to me now, but I’ve never heard it described that way before. Thanks for opening my eyes.
Thanks,
Keith.

• Ben,

Please explain to me the “buying money” thing. Don’t you eventually want to pay a property off or be in a position to collect more CF sooner rather than later?

If you can afford to pay cash for a rental property, is that a good thing?

Thanks

4. Thanks indeed, Keith! I am very fortunate to be in position to offer perspective, and excited that you found it useful.

5. And the key is understanding NOI and how to calculate it or more importantly how will the bank / appraiser calculate NOI. I use 50% expense ratio for class B which I assume includes some set asside for CAPEX. So to me NOI is: (total rents) x 0.5 = NOI. One can build the NOI up from the balance sheet using true expenses. Doing it this way does contributions to the capital account count as an expense or not?

For buying a property, my offer will be based on the NOI including CAPEX contributions as an expense. Or just use 50% expense ratio if the property looks clean and well maintained is my napkin calc. For a clean SFR/Duplex… I might use 40% (multiply by 0.6) expense ratio because you’;ll not get your offers even looked at otherwise.

• Haha – you are getting above pay grade of many folks reading this, Curt.

The CCIM crowd will tell you that CapEx is beneath the fold. But, for you, me, and a few others who know what is going on, CapEx is above the fold.

Now – obviously, if you understand the numbers, this can be an advantage an a refi:) It sound llike you do, but that’s an article on its own…

Thanks so much for reading and commenting!

• Keith – I am not sure if it does. But if not, mine definitely does. In a lot of ways this is what tees up my decision in small multifamily space.

Thanks a lot!

6. Ben – great post! How did you come up with the 1.4 number as your DSCR hurdle?

• Hah – school of hard knock, Conor 🙂

7. Your post is why I love Bigger pockets. It’s another tool in an arsenal of many to analyze a property prior to making the investment. Thanks.
Oh Yes, please tell us how you got the 1.4.

8. That is a great informative post. Thanks for sharing.

9. Ben since you like to play the devil’s advocate let me do it also. A large part of your metric seems to be how much money is available to pay your debt service. However that is not a true measure of how good a deal is. If someone gets a 30 year mortgage, and another person gets a 15 year mortgage, using your calculations the 10 year mortgage makes the property a bad deal if it just breaks even each month. The monthly payment @ 5% for a 15 year loan on a \$100K is about \$790 if the loan is a 30 year loan the monthly payment is \$536. If your monthly NOI is \$540 then the exact same deal will be very different in its.DSCR. Yet the income and expense are identical. To have an accurate view of the deal you need a common metric of financing to evaluate them. I do not cash flow very much but I use mostly 15 year loans not 30 year. The accelerated debt payoff needs to be accounted for.;

• Jerry your math is accurate but your missing the point. Regardless of amortization length the underwriting standards required by most banks will require a DSCR of at least 1.25 in order to ensure their borrower will have the financial wherewithal to still pay the debt service in the event of hardship or disaster. So whether your goal is to pay down debt as quickly as possible or to maximize free cash flow, the debt partner will ensure you are not too thin for your own good. Another good metric is debt yeild or NOI / principal. This tells the bank how much the bank they will have available to cover the debt in the event the borrower fails to fulfill their debt obligations. I agree with Ben and prefer to maximize cash flow versus accelerating debt reduction. I can earn a hell of a lot more reinvesting cash thrown off of the property than by waiting 15 to 30 years to burn debt and wait to capitalize on my investment.

• Making the bank happy is one objective, protecting yourself is the other. The bank is happy with 1.25, but you want 1.4. Jerry doesn’t want 1.4. He’s not looking for cash flow now. He wants to maximize the mortgage pay down so that cash flow is maximized later when he retires. He’s doesn’t worry about DSCR being a little thin because he makes money elsewhere that he can use to pay the mortgage if really needed. So yes, you always have to make the banks happy if you want to use their money, but Jerry’s also right that a higher DSCR is not always better.

Like Jerry, I also use mostly 15 yr mortgages. Cash flow isn’t great now, but the reduction in interest rates is saving me money and when these are all paid off in 5-10 years, we’ll have no reason to keep the day jobs.

10. Give emphasis on DSCR is ok but other ratios should also be given importance while taking decision.

• Other ratios? Heh heh yes like Cash on Cash. We offer at 30% and close at 25%.

11. When I worked in debt/capital all we cared about was DSCR(lender side)! Thanks for the article!

12. Very helpful as usual Ben! You’re one of my favorite writers on BP, you get to the technical parts other people don’t often explain (to many investor’s detriment). Thank you!