Have you already invested in at least one rental property? If so, then you are already quite familiar with the rewards of real estate investment. In fact, you may have decided the next best step is to increase your returns through further investment. But that begs the question: are you also familiar with your debt-service coverage ratio (DSCR)? Learning how to calculate and improve this number helps ensure you qualify for one of the best investment loans around for rental properties. Let’s take a look.
Your debt-service coverage ratio is your net operating income divided by your annual debt services. The average debt service can be calculated by adding together your principals, interests, taxes, insurance, and association dues (PITIA). You may have other expenses to include in the calculation. Your net operating income is revenue generated from the property.
Let’s say your NOI is $150,000, but you have a debt service of $90,000:
- DSCR = NOI/PITIA+
- DSCR= 150,000/90,000
- DSCR = 1.6
Your DSCR would be 1.6. This means you are making more than you spend, so you are pulling in a profit. Most lenders want to see a minimum DSCR of 1.25.
Qualifying for DSCR Loans
Getting a Debt-Service Coverage Ratio loan involves proving that your properties are profitable, proving that you have experience with managing properties, and proving that you are financially savvy. Most lenders will want to see a credit score of around 680, a property value close to $150k, and a minimum down payment or equity.
Despite the requirements, DSCR loans have better terms and are easier to be approved for than conventional loans. The process is much faster than applying for conventional loans, so you should hear back fairly quickly. You also have more flexibility on how many loans or properties to work with, so you can expand your investments rapidly if you have the means.
One downside to DSCR loans is that they do require either a higher down payment or better equity. Some lenders may have additional requirements, so it’s a good idea to study them individually to ensure you aren’t wasting time by applying.
How to Optimize Your DSCR
Knowing and improving your debt-service coverage ratio helps you invest in more properties through DSCR loans and track your Return on Investment (ROI). It’s important to understand how to analyze and improve your DSCR to bring in the best ROI or get the best terms for DSCR loans.
If your DSCR is less than 1, then you are actively losing money on your investment. 1 even means that you are generating as much income as you are spending. The goal is to get above 1; 1.2 is considered okay, while 1.6 is strong in rental properties.
The best ways to improve DSCR for rental properties involve:
- Reduce personal debt
- Strengthen your credit score
- Increase your NOI
You want to pay off outstanding debts for current properties and then reinvest that money. You can also refinance outstanding property mortgages and liens for better terms, leading to an overall better NOI per property. Always be aware of your debts and ways to improve or minimize costs to get more out of your rental income.
Optimizing your debt obligations, in turn, optimizes your financial standing, leading to more negotiation room for DSCR loans.
Words of Caution
While DSCR loans primarily look at your rental property’s income versus debt, it does consider your personal credit score. Don’t focus entirely on your property expenses if you can instead pay off a few personal loans and increase your FICO score.
You can also overextend your DSCR— if you reach, say, a 2 or 3, lenders may wonder why you haven’t been investing more. You may need to submit more information before they’ll approve your loan.
Other Ways to Invest
Even if you aren’t looking into becoming the next real estate empire, you may still want to generate more income through investment. A strong DSCR can help! DSCR loans are primarily for real estate, but a positive DSCR has other benefits: the income left over after paying debts can be returned to your investment fund to finance more investments rather than paying out of pocket, and a positive DSCR improves your overall financial standing for better terms.
Whether you choose to continue investing in real estate or diversify your portfolio, you’ll want to stay on top of the latest financing options so that you can take advantage of the best rates available.