In order for us to see how Debt Coverage Ratio (DCR) is used by lenders to guage a rental property’s cash flow vulnerability, we need to repost the calculation examples we used in our last post.
EXAMPLE ONE: Let’s assume a borrower is requesting a mortgage with annual payments of $40,000 on an investment property that generates a net operating income of $50,000. The DCR computes at 1.25 ($50,000 / 40,000 = 1.25).
EXAMPLE TWO: Now let’s assume a mortgage with annual payments of $50,000 on the same net operating income of $50,000. The DCR computes at 1.00 ($50,000 / 50,000 = 1.00).
EXAMPLE THREE: Lastly, let’s assume a mortgage with annual payments of $55,500 on the same net operating income of $50,000. The DCR computes at 0.90 ($50,000 / 55,500 = 0.90).
How to Apply
EXAMPLE ONE (1.25 DCR): This tells the lender that there are more than enough funds to cover the debt service. Let’s check it: $50,000 (funds available) less 40,000 (mortgage payment) = 10,000. That is, not only are there enough dollars provided to cover the mortgage payment, there are 10,000 more dollars (25% more) than the payment requires. This is a good thing.
EXAMPLE TWO (1.00 DCR): This tells the lender that there are just enough funds to cover the debt service. Same procedure: $50,000 (funds available) less 50,000 (mortgage payment) = 0. That is, there are enough dollars provided to cover the mortgage payment, but nothing would be left over for any margin of error. This is typically not good enough.
EXAMPLE THREE (0.90 DCR): This tells the lender that there are not enough funds to cover the debt service. Once more: $50,000 (funds available) less 55,500 (mortgage payment) = -4,500. That is, there are not enough dollars provided to cover the mortgage payment and would require the owner to make up the difference “out-of-pocket.” This is absolutely not good enough.
As a quick point of reference just remember that 1.0 is break-even, any ratio that’s higher means more than enough to cover the mortgage payment, and any ratio that’s lower means less than enough to cover the mortgage payment. Naturally what ratio a lender is willing to accept is up to the lender, but don’t be surprised to find that most look for a DCR of at least 1.20. Happy hunting.
