How to Calculate Debt Service Coverage Ratio in Real Estate?
Real estate investors use different indicators to assess the financial performance of leased property. One of them is the debt service coverage ratio . It allows you to assess the possibility of a timely repayment of the loan on the property, as well as it’s interest. You can use our simple debt service coverage ratio calculator to calculate this metric.
What is debt service coverage ratio in real estate
Debt service coverage ratio is an indicator that gives the creditor an idea of the ability to provide or repay the annual debt service compared to the amount of net operating income (NOI) that the property brings. In other words, this indicator determines whether the income from the property is sufficient to cover the amount of the mortgage.
How to calculate debt service coverage ratio?
The debt service coverage ratio formula is as follows:
DSCR = Net operating income / annual debt service
To determine the debt service coverage ratio, you must first calculate your NOI. Then dividing it by the annual debt service on your property, you get the debt coverage ratio.
How to calculate net operating income?
Since net operating income has a significant impact on the calculation of the debt service coverage ratio, it is important to be sure how to calculate it correctly.
NOI is calculated by deducting all necessary operating expenses from the total income generated by the property.
The typical list of operating expenses includes: property management costs; utilities; staff salaries; payment for contractual services (telephone, fire protection system, elevator,etc.); insurance fees; maintenance and repair costs; tenant screening fees; legal feel, accounting and auditing services; pest control costs; entertainment expenses; etc.
Lastly, according to the net operating income formula you need to bring down the costs of all your gross operating income on your property so they will be lower than the amount of operating expenses.
The Net Operating Income formula is as follows:
Net Operating Income = Gross Operating Income – Operating Expenses
What is a good debt service coverage ratio?
If, as a result of the calculation, the debt service coverage ratio is less than 1, it means that the income received by the investor is less than their monthly debt obligations. In this case, you need to look for additional resources to cover interest on loan obligations. On the contrary, if the value of this indicator is greater than 1, the investor’s income exceeds their monthly debt and is sufficient to cover it. If, as a result of the calculation, the debt service coverage ratio is equal to 1, it means that the investor’s income from real estate is equal to their monthly debt.
Usually the level of the debt service coverage ratio is considered good if it ranges from 1.25 to 1.5. This means that your rental property brings 25-50% more additional income after paying monthly mortgage debt.