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Money and money ratio

What Is a DSCR Loan?

Researching commercial real estate financing? Then you've probably come across the term "DSCR loan" and been utterly confused by its meaning. So, allow this article to clear it up for you. 

Debt Service Coverage Ratio Loans (DSCR Loans) are mortgages designed for companies or individuals investing in real estate. Whether it's a single-family home or multifamily housing, these loans give you the freedom to set your personal income aside and draw on your business's DSCR to qualify for significant funding to expand your portfolio. 

Key Takeaways

  • A DSCR loan is a commercial mortgage loan designed for residential rental units. Rather than relying on personal income, it uses your company's debt service coverage ratio and is underwritten on the property itself.
  • DSCR loans are designed for investors following niche strategies, self-employed real estate investors, and those who invest in real estate with teams or partners.
  • DSCR is calculated by dividing your net operating income by your total debt service.
  • Even though there aren't any industry standards, two is considered to be a very strong debt service coverage ratio.

What Is a Debt Service Coverage Ratio (DSCR) Loan?

A DSCR loan is a mortgage for residential income-producing units, based on the debt service coverage ratio rather than personal income. These loans are strictly for business purposes, using the property's future rental income for underwriting.

Unlike traditional mortgages that require income verification, DTI ratio, and tax returns, DSCR loans simplify the process, making them ideal for professional real estate investors and companies seeking less paperwork.

How Does a DSCR Loan Work?

DSCR loans offer a way for professional real estate investors to finance their next unit purchases without their personal income impeding their borrowing power.  

To do this, the lender determines whether the future rental income generated by the underwritten property will be enough to cover the payments, reducing their risk and improving the likelihood of the loan being approved.

They do this through the DSCR, an industry-wide metric to gauge how much income may be generated from a given property.

Such loans also come with less restrictive covenants than other loan types, giving you enough flexibility to run the property how you want and make value-adding decisions to increase your ROI.

How to calculate DSCR

Why Is the DSCR Important?

The debt service credit ratio measures a company's ability to meet debt obligations using the cash flow generated from operating activities. It's a widely used indicator of an organization's financial health.

"Debt service" is the cash required to pay the business's required interest and principal during a predetermined period. "Ratio" is the company's entire debt obligations compared to its operating income. Everybody from partners to lenders to stakeholders pays close attention to an entity's DSCR metrics.

As a corporate borrower, it will impact your ability to gain approval for various loans and financial vehicles, particularly DSCR loans. But this credit metric changes more than your business borrowing opportunities — it can influence investors' decisions too. 

How To Calculate DSCR

While there are many convolutions in the DSCR calculation, the bare formula is as follows:

DSCR = Net Operating Income / Total Debt Service

So, to calculate your company's DSCR, you need to know your net operating income and your total debt service. The latter, as we briefly explained above, is the total amount of your business's current debt obligations (i.e., lease payments, interest, principal, sinking fund, etc.). The former, however, involves doing another calculation (shown below):

Net Operating Income = Revenue - Certain Operating Expenses

Certain operating expenses (otherwise known as COE) do not include interest payments or taxes. 

When calculating your DSCR specifically for a DSCR loan, however, the calculation changes slightly, as per the following:

DSCR for DSCR Loan = Rental Income / PITIA

In this case, PITIA is the sum of the principal, interest, taxes, property insurance, and association dues.

If you're having trouble with the calculation, there are plenty of online calculators you can turn to. For the most accurate results, use one related to a DSCR loan. You'll likely need to input the following information:

  • Loan amount
  • Interest rate (percentage)
  • Interest-only (yes or no)
  • Annual rents
  • Annual property insurance
  • Annual property taxes
  • Annual HOA dues
  • Annual flood insurance

What Is a Good DSCR?

Lenders will assess your DSCR, so it's helpful to know what a good score is ahead of time.

A DSCR of one shows your company has precisely enough cash flow to repay its debt service costs. However, you should be aiming for a DSCR of at least 2.0. While there isn't an industry standard, most lenders deem this score very strong. After all, it shows your business can cover double its debt.

However, if you have a debt service coverage ratio of less than one, you have negative cash flow. In other words, lenders will conclude that you might be unable to pay your current debt obligations without receiving help from external sources or borrowing more money. To make the scale easier to understand, note that a DSCR of 0.95 means you only have enough operating income to cover 95% of your yearly debts.

Most lenders set minimum DSCR requirements. These tend to run between 1.2 and 1.25.

With all that DSCR knowledge tucked under your hat, it's time to dive back into the loans.

Who Is a DSCR Loan For?

DSCR loans are great for investors in residential real estate rental units. Both first-time investors and well-established professionals can take advantage of DSCR loans, thanks to their flexibility and relatively easy qualification.

While you may already have a good indication as to whether this type of loan is right for you, the following three profiles are best suited to this financial vehicle:

Self-Employed Individuals or Freelancers Looking to Invest in Real Estate

If you do not have a W2, obtaining traditional financing for investment properties is notoriously difficult. Conventional lenders prefer to see at least two years' worth of regular employment and income. Plus, they'll use this data to calculate your debt-to-income ratio, adding another block in the road.

In contrast, debt service coverage ratio loans do not use a W2, debt-to-income, or your personal income during the qualification process. As we've mentioned before, it's based on the revenue-generating potential of the property instead.

Investors Following Niche Strategies

Traditionally, DSCR loans are used for straightforward rental properties on long-term leases. Think of single-family rentals on year-long contracts. However, providers of these loans have been quick to adapt to emerging, highly profitable modern trends, such as the BRRRR method (buy, rehab, rent, refinance, repeat) and short-term rentals, and are increasingly used in these niches. 

Experts report that investors who are thinking outside the box are turning toward these products more often than conventional financing to max out their cash flow.

People Who Invest in Real Estate with Partners

Partnering often makes sense in real estate investment. Many people find it beneficial to partner with complementary skill sets, forming a formidable team.

However, conventional financing doesn't allow shared ownership without relentless forms and paperwork. DSCR loans, on the other hand, do allow shared ownership without so much hassle. They do this by allowing you to borrow in a partnership or limited liability company.

Who Qualifies for a DSCR Loan?

Qualifying for a DSCR loan is certainly easier than traditional real estate financing. But that doesn't mean it's completely paperwork-free.

As previously described, one of the most important qualification criteria is having a strong debt service coverage ratio. This measures the property's ability to create income to cover the related debt obligations. Most lenders have a minimum DSCR of 1.2 to 1.25, but a rating of two is considered strong.

Alongside this score, you will need to provide various documents. These are as follows:

  • The application containing basic details about the property and your company. 
  • A signed credit authorization form allowing the lender to run a credit and background report. 
  • property value appraisal.
  • Bank statements showing that three to six months of liquid assets are available to cover the debt during vacancies or turnovers.
  • If the property is a long-term, occupied rental, you'll need to provide the lease or leases.
  • If the property is a short-term rental and you have access to 12 months of operating data, you will need to provide the short-term rental history.
  • Property insurance with the lender's information.
  • Flood insurance provided the property sits in a federally recognized "Flood Zone."
  • The entity documents, including the Certificates of Good StandingCertificate of Formation, and the Articles of Organization and Operating Agreement. This is only necessary if you're borrowing as an LLC.
  • Renovation documentation, including receiptswork orders, and invoices from the work. You only need to provide this if you are following the BRRRR method and are using a DSCR loan for a rapid refinance.

Depending on the lender, the property may have to fall into specific eligibility criteria, even though these loans can be utilized for multifamily properties, industrial spaces, commercial buildings, and other real estate investments.

When To Use a DSCR Loan

When used correctly, DSCR loans can be powerful investment vehicles, affording you the ability to expand your rental portfolio. However, they do come with a higher down payment cost. As such, they're best used when you have the liquid cash to pay at least a 20% deposit on your next property.

Advantages and Disadvantages of DSCR Loans

Like any financial vehicle, there are various advantages and disadvantages to consider with DSCR loans. On the surface, they may seem like the next step in your property investment career, but conduct thorough research before deciding they're the best route for you.

Advantages of DSCR Loans

DSCR loans come with these benefits:

  • Underwritten by property cash flow. Generally speaking, loans need proof of personal income before a lender will grant them because lenders need assurance that you can repay the loan. If you don't make enough, you are less likely to be given the loan, making it difficult for you to invest in bigger real estate opportunities. However, DSCR loans are based on the difference between the property's forecasted cash flow and its total expenses. If the ratio is higher than one, then its cash flow can cover the debt and the lender is more likely to approve your application. 
  • Faster than conventional loans. To get ahead in the real estate investment world, you need to act quickly. If you attempt to use a regular loan for the purchase, the seller will likely grow impatient and may move on to other investors before your loan application is finalized. DSCR loans are made for property investors, necessitating less paperwork and boasting lightning-fast processes. Ultimately, this will allow you to move forward with a viable answer much faster.
  • Uncapped number. Do you want to be an investor with multiple properties in your portfolio? You can do that with DSCR loans, depending on the lender. Many providers don't limit the number of DSCR loans you can get. Therefore, if each property has a debt service coverage ratio greater than one (or the specific lender's minimum), you can have it as your next investment. With this sort of borrowing power backing you up, you can rapidly scale your real estate portfolio.
  • Doesn't interfere with personal finances. When buying a rental property with a standard mortgage, you have to make sure the payment for the new unit fits into your monthly personal household budget. Not only does this stretch finances too far for many, but it can also limit your future borrowing power. But with DSCR loans, you can separate your household finances from your investments, giving you much more wiggle room to invest in a worthy property.

Disadvantages of DSCR Loans

In addition to the benefits, take note of these disadvantages to make an informed decision about DSCR loans:

  • Higher down payment. While this isn't always the case, some lenders require a larger down payment compared to standard mortgages. To qualify, you may need around 25% of the property value upfront. As such, you need a relatively large amount of capital to spend to be granted the loan that covers the rest. Depending on your current financial state, this may be a barrier to entry for you.
  • Better credit is required. For the most part, DSCR loan lenders don't take your personal finances into account. However, as part of their qualification process, they will run credit inquiries to establish whether you have a history of making timely payments. Despite underwriting the loan based on the expected income from the property, they still want it to be backed by a reputable individual. This is how they determine whether you're a trustworthy individual. If your credit score isn't up to scratch, you may face resistance from most providers.
  • Potential volatility. If the income the property generates is equal to the DSCR loan payment, you won't have any money left over. Therefore, most lenders require a DSCR of 1.25 or 1.5. However, this minimum may be hard to achieve when the rents are low compared to the value of the property, negatively impacting your eligibility. Likewise, any changes in rental market conditions once you've acquired the loan could ruin your ability to pay. That said, some experts note you could counter this by implementing the BRRRR method.

DSCR loans can be convoluted, but with the in-depth guidelines above, you're more than ready to tackle their nuances. Just remember to conduct thorough research and think carefully about the advantages/drawbacks before signing on the dotted line.

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