CHAPTER 29
Calculation 23: Debt Coverage Ratio
What It Means
Debt coverage ratio (DCR) is the ratio between the property’s net operating income (NOI) for the year and the annual debt service (ADS).
If your NOI and ADS are exactly the same (say $10,000), then the ratio is 10,000 divided by 10,000, or exactly 1.00. A DCR of 1.00 implies that you have exactly enough net income from the property to make your mortgage payments, not a nickel more or less. If your DCR is less than 1.00, it means the property does not generate enough income to pay the mortgage. If your DCR is greater than 1.00, then the property does generate enough, with some left over.
As you might expect, one person with reason to look at the DCR carefully is the mortgage lender. When you try to finance a property, that lender will examine the DCR to see if the property can expect to generate enough cash to cover its mortgage payments. You can be certain that “just enough” (i.e., 1.00) is not good enough. The lender wants to be sure that there is a margin for error, so both the current DCR and its future projections must be higher than 1.00.
How to Calculate
Debt Coverage Ratio = Annual Net Operating Income / Annual Debt Service
For a given year, first calculate the NOI and the ADS; then divide the former by the latter.
Each of these two components is discussed in greater detail elsewhere in the book, so we’ll review them very briefly here:
1. Net Operating Income = Gross Scheduled Income, less Vacancy and Credit Loss, less Operating Expenses
a. Your gross scheduled income is the total rent you expect to receive if all units are occupied and all tenants pay as agreed.
b. This expectation may be reduced by the vacancy and credit loss, a loss of income that can occur if one or more units are unoccupied for a period of time or if some tenants simply fail to pay.
c. Operating expenses can include items such as taxes, insurance, maintenance, supplies, trash removal, advertising, etc. Mortgage payments, interest, and depreciation are not operating expenses.
2. Annual Debt Service = Monthly Mortgage Payment × 12
ADS is the total of mortgage payments for the year. If you make monthly mortgage payments, then the ADS equals that monthly payment times 12.
Example
You’re considering the purchase of a four-unit apartment building. Each apartment rents for $800 per month. During the year recently ended, one unit was vacant for two months, but all the others were occupied continuously. All tenants paid their rents on time.
The property’s operating expenses for the year were as follows: taxes, $6,000; insurance, $1,400; maintenance and repairs, $1,200; supplies, $400; and water, $600.
You are applying for a mortgage so that you can purchase the property. The monthly mortgage payment of principal and interest will be $2,000.
First, calculate the NOI.
Gross Scheduled Income = 4 units × $800 per month × 12 months = $38,400
Vacancy and Credit Loss = 800 × 2 months = $1,600
Operating Expenses = 6,000 + 1,400 + 1,200 + 400 + 600 = $9,600
The NOI calculation looks like this:
Second, figure the ADS:
Annual Debt Service = 2,000 monthly payment × 12 = $24,000
Finally, calculate the DCR:
Debt Coverage Ratio = 27,200 (NOI) / 24,000 (ADS) = 1.13
Test Your Understanding
In the example above, the DCR is not high enough to satisfy most lenders. What NOI would be necessary to achieve a satisfactory DCR? Is there a way you might make your case to the lender, suggesting that the property would indeed meet the debt coverage requirements?
Answer
If:
Debt Coverage Ratio = Annual Net Operating Income / Annual Debt Service
then you can transpose the formula to read:
Debt Coverage Ratio × Annual Debt Service = Annual Net Operating Income
In that case, if you’re seeking a DCR of 1.20,
1.20 × 24,000 = Annual Net Operating Income
$28,800 = Annual Net Operating Income
With ADS of $24,000, you would need an NOI of $28,800 to achieve a DCR of 1.20.
Now, what do you say to the lender that doesn’t like your original numbers? Remember that you are using last year’s property history—a year in which one of the apartments was vacant for two months. As you prepare to purchase the property, you have no vacant units. Instead, the property is fully occupied with good, never-delinquent tenants. You might argue that, in the coming year, you can reasonably expect not to incur the $1,600 vacancy loss. Eliminating that loss would raise your NOI from $27,200 to $28,800, exactly what you need to achieve the lender’s required DCR.