The Debt Coverage Ratio or DCR is the lender’s primary way of generating lender safety when making a loan on an income property. The DCR will specifically calculate the maximum amount of loan that the lender should make for any given income stream.
Why Lenders Think This Way: All lenders are absolutely aware of the risk of lending too much money on a property. If the lender is the only one with “skin in the game” the borrower may find it both easy and convenient to simply hand a bag of keys to the lender and given them the tenant rent roll, and walk off from a property that is generating too much negative cash flow.
In order to assure that an income property can safely service the monthly payments, the lender makes a loan that forces the property to generate a positive cash flow. “Never lend so much money that there will be negative cash flow”… the mantra of the commercial mortgage lender.
How the DCR Is Applied:
1. Determine a conservative estimate of the property’s Net Operating Income
Example: NOI = $150,000 per year
2. Divide the Net Operating Income by the lender’s selected DCR (e.g. 1.30)
Example: $150,000 / 1.30 = $115,385 in annual debt service (PI only)
3. Divide the annual debt service to determine allowed monthly debt service
Example: $115,384 / 12 = $9,615 PI per month
4. Calculate the size of loan that would be amortized by the allowed monthly payment (use a present value calculator such as a HP10BII)
Example: if the interest rate is 6.5% and the allowed amortization term is 30 years, then the maximum sized loan that $9,615 per month would amortize is $1,424,000
The lender now knows that if the maximum allowed loan is $1,424,000 on a property that can safely generate $150,000 in annual NOI or $12,500 in monthly NOI, the investor will receive the “left-overs” after making the mortgage payment.
Restated (Investor’s View): $12,500 in monthly NOI – $9,615 in monthly payment = $2,885 in monthly cash flow to the investor.
Restated (Lender’s View): The property would have to slip at least $2,885 in lost income or increased expenses before the lender would fear a late payment or worst yet a missed payment. Force the investor to have positive cash flow, and you will have little chance of getting the property given back to the lender.
My Opinion: The “good old days” of low Debt Coverage Ratios is over! Lenders understand that there is no glory in foreclosing on a property, only to discover a visit from a bank auditor can force them to “mark the asset to market”, thus forcing the lender to show a loss on their balance sheet
Contact me, and I will suggest several names of lenders who could give you hints on current Debt Coverage Ratios for the type of property that is of interest to you. Tuition is just too high to learn this information through the School of Hard Knocks. Amateur Night should only play in the evening at the local TaTa bar.
Email Rene’ or call (541) 912-6583
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