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