Debt Service Coverage - What does that mean?
How much debt will a property support?
Purchasing real estate within an IRA is a good place to invest IRA funds, especially with today’s excellent buys in real estate where markets have turned south. What that means in terms of returns on investment for your IRA are yields better than bank rate CD’s, Wall Street stock and mutual fund returns, and other investments. Your investment strategy and risk tolerance determines where your IRA invests, if a property truly does provide positive returns to the IRA, and if an IRA loan (non-recourse loan) makes sense for a property. Investment strategist’s can provide you with all kinds of formulas for returns on investments. You or your financial advisor or CPA can help make those numbers more clear. What I want you to examine are the impacts of debt on a property and how much debt a given property can support from a lending perspective.
Say you are a flipper and will be reinvesting capital gains in a relatively short time frame. In that case, you may not be too concerned about monthly cash flow if the end strategy is to make the profits on capital appreciation. You probably don’t even want a tenant in a property that you want to sell as soon as possible and want the home to show well. In that case, our reserve requirements would be larger than an income producing property.
However, if a longer-term approach, based on rental income is taken, then First Western Federal Savings Bank is going to look at Debt Service Coverage Ratio (DSCR) and how much debt a given property will support. Let’s look at the components that make up Debt Service Coverage and why it is important to examine.
Debt Service Coverage Ratio by definition is the Net Operating Income a property can generate, divided by the amount of Annual Debt Service (principal and interest payments).
Let’s look at an example, using the expense ratios we use, so that you can for yourself identify these components and make an educated choice on your target investments.
Our requirement is at least a 1.25 debt service coverage ratio.
Let’s take for example a Single Family Residence (SFR) that has a purchase price of $200,000. It can be rented for $1500 per month. For sake of discussion, let’s assume a 50% loan-to-value of $100,000 non-recourse debt financing. How do these numbers play out?
Total Income Annually = $1500 per month rent times 12 months = $18,000 income.
From that we need to subtract operating expenses.
|Taxes (say $3000 per year)||3000|
|Insurance (say $800 per year)||800|
|Home Owner Association dues (say $160 per year)||160|
|Vacancy (we use 7% of gross rental income annually)||1260|
|Maintenance (we use .6% of the purchase price)||1200|
|Management (we use 10% of gross rental income)||1800|
|Total Annual Expenses||$8220|
|Net Operating Income ($18,000 income minus expenses $8220)||$9,780|
Now to figure Debt Service Coverage Ratio we take the Net Operating Income of
$9,780 and divide that figure by the annual debt service on the $100,000 loan.
Principal and Interest ($100,000, 25 year loan @ 5%) = $584.59/mo.= $7015.08/yr.
DSCR then is $9,780/$7015.08=1.39
If a larger IRA loan was considered (say 60% LTV) of $120,000, then the principal and interest payments would increase to $701.51 per month or $8418.10 annually. What would this do to the ratio of this same property? Plugging that number then into the DSCR we find $9,780 income/$8418.10 debt service equals debt service coverage ratio of 1.16.
A quick analysis of both loan sizes tells us that the property does support a loan of 50% of the purchase price, but does not support a 60% loan-to-value (LTV).
You can use this simple formula and make these same calculations on any given property you are interested in to find out how much debt the property can support. The Debt Service Coverage Ratio will be different in each market of the country as the relationship of rental income that can be generated versus the purchase price varies widely from one area of the country to the next.