Debt Coverage Ratio

Overview

While investors ask about cap rates and gross rent multipliers to determine whether or not a property meets their investment criteria, lenders tend to focus on something called the debt coverage ratio (DCR). You may not be as familiar with this metric, but you can bet that your lender or mortgage broker is intimately familiar with it because the DCR can determine financing options for a property.

Definition

The debt coverage ratio is the ratio between a property’s net operating income and the annual debt service (12 months of mortgage payments) for the property. A lender that requires a higher DCR means that the net operating income must be higher in order to cover the mortgage payments. In Southern California, most lenders expect a minimum of 1.15 DCR for apartment properties. However, more aggressive lenders have been known to employ a DCR lower than 1.15, depending on such factors as borrower strength, property characteristics, and forecast income. In some cases, a higher DCR requirement (such as 1.25, even up to 1.55) may mean lower rates to the borrower.

As discussed, you divide the NOI by the annual debt service to determine DCR:

Net Operating Income / Annual Debt Service = Debt Coverage Ratio

The net operating income is the property’s gross income minus vacancy loss and operating expenses.

The annual debt service is the total of mortgage payments for the year.

If you are looking at a range of financing options, you may want to ask about the DCR for each loan program to get an idea about the maximum loan a property can support:

NOIInterest RateDCRListing Price
$100,0006.50%1.15$2,000,000
$100,0006.50%1.20$1,818,182
$100,0006.50%1.25$1,666,667

All things being equal (NOI, Interest Rate, and Amortization), higher DCR requirements can result in lower loan amounts. As a reference, in cases where a higher DCR offers a lower interest rate to a borrower, the rate is often not low enough to offset the decrease in maximum loan dollars attainable.

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