Real estate investment can be a lucrative way to build wealth and achieve financial freedom. However, getting started in real estate can be challenging, especially when it comes to financing. While your options are fairly limited for a first-time investment, following investments have more options since you have now created a financial record. One of the most popular options for real estate is the DSCR loan. In this article, we’ll explore what a DSCR is, how it can help you qualify for a great loan, and how these loans can help you achieve your investment goals.
DSCR stands for Debt-Service Coverage Ratio. Lenders use this tool to determine a borrower’s ability to pay back their loans, especially if they are seeking to take out a new one. DSCR is calculated by dividing your Net Operating Income by your Annual Debt Obligations. Here are the formulas for calculating everything:
- DSCR = NOI / ADO
- NOI = Gross Revenue – Property Operation Costs
- ADO = payments for debts within the fiscal year, including loan and mortgage principals
- Property Operation Costs = utilities, staff, etc. added together
As an example, let’s say a property has a NOI of $300,000, but you spend $200,000 each year paying down debts. Your DSCR would be 300,000/200,000, or 1.5. This means your property makes enough in a year to pay your debts 1.5 times over.
DSCR has three tiers:
A DSCR of less than one means your business is operating at a loss and will not qualify for a DSCR loan— in fact, your loan options will be practically nonexistent. A DSCR of 1 means you are making just enough to cover your debts, and your loan options will be limited. A DSCR of greater than one means you are operating at a profit, and lenders will be more likely to take the risk. For a DSCR loan specifically, you want a minimum of 1.25.
Since DSCR is basically your profit margin, you have three main ways to boost it: increase your profits and increase cash flow, reduce your expenses, and pay off current debts. Seeking the help of a business analyst or a financial advisor can help you target ways to do so. Prioritize high-interest loans, as these often have high payment amounts and largely contribute to your ADO.
A DSCR loan is a real estate investment loan targeted at commercial real estate owners, rental property owners, and every investor level in between. You will need a DSCR of at least 1.25 to qualify, alongside other criteria, but DSCR loans offer great benefits for investors. Rather than personal income, these loans are based on property-level cash flow.
DSCR loans often offer lower interest rates, higher loan amounts, and longer repayment terms compared to other business loans.
The main things lenders look at are as follows:
- DSCR. Most lenders want to see a minimum of 1.25, though some want higher based on Loan-to-Value percentages.
- FICO. Lenders will look at your business credit, and they may also look at your personal credit score.
- Business Record. Lenders want to see a record of success and profit with managing your current or starting property. They want proof that you can manage your rental finances well.
- Industry. Some industries are risker than others. Your lender may request additional information before coming to a decision.
- Collateral. DSCR loans are secured by collateral. The value needs to be equal to or greater than the amount you want to borrow. You can use property or equipment to secure your loan.
Your preferred lender may have additional requirements. Narrow down your lender options and then check the top three’s requirements before getting your documentation together.
With a higher amount spread over longer repayment terms with lower interest rates, you can probably see why DSCR loans are so popular in real estate investment. They have a significant impact on your cash flow and help you grow your portfolio. You can also use them to consolidate previous loans, improving the cash flow further.
If you aren’t interested in consolidation, you can instead invest in larger or multiple properties. In addition to helping your profit margins, you may see an increase in appreciation, as well. DSCR can help you build up your properties as you use the NOI of your first rental to purchase your second, then from both to invest in a third, all three for the fourth, and so on.
Additionally, by expanding your portfolio and paying all of your loans on time, you will boost your business credit score further to qualify for even better terms.