As a multifamily apartment investor, debt service coverage ratio (DSCR) is one of the key calculations you’ll need to know. Here we explore what DSCR is, share the debt service coverage ratio formula, and explore factors that affect DSCR.
What is Debt Service Coverage Ratio?
Debt service coverage ratio is a commonly used method to determine a borrower’s ability to pay off mortgage debt (including the principal and interest loan payments). The higher the debt service coverage ratio is on your project, the easier it is to obtain good financing terms with a lender.
Many lenders require a DSCR of at least 1.25% of the debt payments. This allows room for increases in vacancies or expenses, to ensure payments can continue to be made until the owner and management company make adjustments to increase the Net Operating Income (NOI).
Factors that Affect DSCR
When purchasing a multifamily apartment project, investors need to look at the DSCR of the current project. There are several factors that can affect the DSCR:
- Look at the current occupancy levels. An increase in occupancy can have a big impact on the NOI and increase the DSCR significantly.
- Investors should also look at the occupancy rates of other similar projects in the area, with similar amenities. Bringing in a new management company with a strong track record could be very helpful.
- Investors may also consider making capital improvements to increase rents, and look at where expenses can be reduced.
Debt Service Coverage Ratio Formula
Understanding how to calculate debt service coverage ratio can help you anticipate the kind of loan offers you’ll receive. The DSCR calculation formula is as follows:
Net Operating Income / Annual Debt Service = DSCR
To help you with your DSCR calculation bear in mind that the underwriter will:
- Utilize 5% to 7% vacancy (depending on the loan program) to calculate occupancy. Even if the project is 100% occupied, lenders use this measure to minimize risk.
- Prepare annual proforma for income and expenses.
- Use the current rents that reflect on the rent rolls. The lender will not use projected future rents.
- Use a 5% fee for management. Even if you self-manage or pay a lesser %, this is the average that most lenders use for qualification purposes.
- Make sure that the property taxes are reflected correctly in the expenses.
- In the expenses for the pro-forma, increase the expenses by approximately 3%, especially for utility expenses.
- Calculate initial reserve for replacements at $1,000 per unit. It ranges anywhere from $250 to $400 per unit per annum thereafter. This account is for major repairs or replacements, for items like windows, roofs, HVAC systems, water heaters, and more.
When refinancing a project, it is important to have a trailing 12-month income statement with a steady debt service coverage ratio that does not show large variations in income due to significant drops in occupancy levels. Lenders look for a stable project that has a stable income and expenses breakdown with the exception of capital improvements that can be backed out for NOI purposes.
Find the Right Loan Program for Your Project
LSG Lending Advisors can help you calculate your DSCR and find the right loan program for your multifamily apartment project, student housing, senior housing, or healthcare facility project. Our lenders will help you secure the best terms and rates. Schedule a free phone consultation today.