Real estate investing can be lucrative, but there are a lot of expenses involved. Whether you sell or rent your properties, you have to deal with mortgages, renovations, utilities, and more. However, people who invest in rental properties have an extra tool at their disposal thanks to the metric called DSCR or Debt-Service Coverage Ratio. This performance number looks at your property’s income versus its expenses to determine your eligibility for special rental loans to invest in future properties or refinance the current ones. Let’s take a closer look.
What is DSCR
At its most simple, the Debt-Service Income Ratio takes a property’s net operating income and divides it by the property’s expenses, also known as debt services. These debts can range from mortgage payments and interest to property taxes and insurance. Even utilities and services like landscaping can count. The resulting number is your DSCR.
A DSCR of 1 is ok but not great. It means that your property brings in enough money to pay for itself. A DSCR higher than 1.0 means you are actually pulling a profit, whereas a lower one means you are losing money on the investment.
How Can You Increase Your DSCR?
A DSCR of one or below is bad for your returns, as you either have no or negative cash flow. To increase your DSCR, you need to improve your properties’ performance. This can be anything from increasing property value to decreasing expenses. If you have a vacant property, then you need to step up marketing your rental property to bring in tenants.
Increasing property value generally means making renovations and exterior improvements. By raising the value, you can also charge more for rent to raise the income. Be careful with rent increases, however— it can sour your relationship with your tenants, and some states have very strict regulations on how to handle rent increases.
The best option is to work on paying off your current debts or refinance for better rates. If you have a positive cash flow, you should split your profit between buffering your cash reserves, paying yourself, and paying off your debts. Once you pay off a property loan, you can take the additional income and add it to the profit while working on the next loan. The more loans you pay off, the lower your debt services, the higher your overall DSCR.
How Can DSCR Help You Grow Your Portfolio?
DSCR helps your real estate investments in two ways: it allows you to track property success for commercial or residential rental properties, and it opens a new financial aspect to funding future rental properties.
By tracking your DSCR, you can evaluate what properties are performing well and what properties are not. This can indicate a need to make changes to how you manage the property or the need to take a loss and sell so that your overall DSCR and income improve. If you learn how to estimate DSCR as lenders do, you will also have an easier time estimating a property’s potential within its local market.
DSCR is also an important metric used by lenders to determine your eligibility for certain rental loans, including the DSCR loan. DSCR loans have a quicker underwriting process than conventional mortgages because 1) they aren’t regulated by Fannie Mae and Freddie Mac, and 2) they look at the property’s potential and your management history rather than your personal income.
How Are DSCR Loans Different from Conventional Loans for Investors?
DSCR loans require less complicated paperwork to apply for, so it’s often easier for investors. You won’t have to go digging through your taxes and various income streams, which is especially helpful if you are self-employed.
DSCR loans can also be taken out for higher loan amounts, with the highest on record reaching $5 million for investment. DSCR loan rates can be higher, around 1-2% above a traditional loan, but they offer a longer repayment period with a lower monthly payment. This makes it easier to balance your debt services with your net operating income.
DSCR loans have a higher LTV, so investors should expect an average down payment of 20-25%, though they have gotten into the 40% for specific loan terms.
What Do You Need to Qualify For DSCR Loans?
Requirements will vary based on the lender and the loan terms you are looking for, but you can generally count on needing a minimum credit score of 640 and DSCR of 1.25. Always check in with a lender before applying to check their specific requirements and what documentation they might want.
For standard DSCR loans, you may need to provide the property appraisal. If you have previous property management experience, gather that documentation as well. A history of success shows that you are at a lower risk than other borrowers, increasing your chance of approval.
How Can You Use DSCR Loans?
DSCR Loans can be used to finance, refinance, or cash out rental properties. They can only be used for rental properties, so they won’t work for house hacking. However, because of their better loan terms and easier application process, they are more convenient for investment rental properties. The better your DSCR, the better terms you can negotiate with a lender.
By using DSCR loans and steadily paying off your debts, you will have the potential to grow your real estate portfolio as much as you wish.
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