A debt-service coverage ratio (DSCR) loan is a loan that’s issued based on a person or business’s ability to pay its debt obligations. Both investors and companies use these types of loans often, mainly to get easier access to capital. In this article, I’ll explore DSCR loans and how you can leverage them to your advantage.

What Is DSCR and How To Calculate It?

A debt-service coverage ratio (DSCR) is a financial metric that analyzes an entity’s ability to pay its debt. The basic formula to calculate the DSCR is:

DSCR = Net Operating Income / Debt Obligation 

A DSCR of 1.0 reveals that a borrower has just enough cash flow to pay off its debt obligations. A DSCR of greater than 1.0 shows that a borrower has more than enough cash flow to repay their debt. And, a DSCR of less than 1.0 shows that a borrower does not have enough cash flow to repay their debt. Lenders will examine the DSCR when determining whether or not to approve a loan. DSCR loans are based almost entirely on the DSCR.

With that in mind, let’s examine the two most common scenarios where DSCR loans are used: real estate investing and business. 

Real Estate DSCR Loan

DSCR loans are common in the real estate industry as they can help investors qualify for loans without relying on their personal income. Traditional mortgages require borrowers to disclose personal financial information like pay stubs, employment history, and W-2 tax returns. However, DSCR loans don’t ask for any of this. Instead, lenders issue DSCR loans based on the projected profitability of the deal.

Real estate DSCR loans follow this formula:

DSCR = Net Operating Income / Debt Obligation 

In this example, “net operating income” is the projected revenue from a real estate rental, and “debt obligations” are all of the costs associated with owning that property (mortgage payment, taxes, upkeep, HOA fees, etc).

For example, let’s say you want to buy a rental property and project that this investment will generate $5,000 per month or $60,000 annually in rental cash flow. If your debt obligations from the property are $50,000 annually then your DSCR is:

$60,000 / $50,000 = 1.2

A DSCR of 1.2 tells the lender that your property should generate enough cash to cover all expenses. Most real estate lenders consider a DSCR of 1.2 or greater to be acceptable and will likely approve a loan if you can prove this metric. However, lenders may still have other requirements like a good credit score or a minimum loan amount. 

To get a better idea of why lenders use this metric, it’s helpful to think of the opposite scenario. Imagine that you’re a real estate investor who is applying for a DSCR loan. Your projected revenue is $60,000 annually. But, your debt obligations will be $80,000. This means that your DSCR will be 0.75% ($60,000 / $80,000 = .75%). In other words, your property will not generate enough cash flow to pay the property’s mortgage and expenses. In this scenario, lenders will not want to lend you money as you’ll have a tough time being able to repay it. If this is the case, you may want to reexamine your calculations and maybe even the deal itself. 

DSCR loans are not reserved for real estate investors. They can also be used in the business world.

Business DSCR Loan

A DSCR loan can also measure how much cash flow a business has to generate in order to repay the required principal and interest on a loan during a given period. Calculating the DSCR ratio for a business loan is a bit trickier than for real estate loans. It starts with the same basic formula: 

DSCR = Net Operating Income / Debt Obligation 

But, in this scenario, “net operating income” is a company’s revenue minus operating expenses not including taxes and interest payments. “Debt obligations” refers to all short-term debt, interest, principal, sinking fund, and lease payments that are due in the coming year.

For example, if your company’s net operating income is $1,000,000 annually and your total debt is $250,000 then your DSCR would be 4. This means your business has 4 times the amount of cash it needs to cover its current debt obligations. 

Lending requirements are a bit more complex when it comes to business DSCR loans. However, lenders will still view your DSCR as an indicator of loan risk. Businesses with a lower DSCR are considered riskier than those with a higher DSCR. Having a low DSCR could impact your company’s ability to raise money or force you to take on debt with less favorable terms.

Pros and Cons

Since they have less strict requirements, DSCR loans can make it easier to raise capital for your business or an investment project. For example, it can be easier to buy a rental property using a DSCR loan since the loan is based on the profitability of the project – not your personal income.

Pros:

  • Easier to get approved: A DSCR loan can be an easy way to raise capital for both real estate investors and businesses in good financial standing. There are usually fewer hoops to jump through when compared to other forms of financing.
  • Financial forecasting: The DSCR metric can also be beneficial for companies and investors as a way of analyzing their financial health. Consistently monitoring your DSCR will let you know if your ability to repay debt is improving, getting worse, or staying the same over time.

For some investors, the concept of a DSCR loan may sound too good to be true as it allows you to qualify for a loan without having a high income. However, there are a few downsides to this form of financing.

Cons:

  • Less favorable terms: DSCR loans often come with less favorable terms, such as a higher interest rate or shorter repayment schedule. 
  • Higher fees: This form of financing may charge origination fees and other fees that can increase your cost of borrowing.
  • Fewer protections: DSCR loans are less popular than other forms of financing, which means there tend to be fewer protections in place.

I hope that you’ve found this article valuable when it comes to learning about DSCR loans. If you’re interested in learning more then please subscribe below to get alerted of new investment opportunities from InvestmentU.