When a bank lends you money on a deal, they want to be certain your property can support the annual mortgage payments. The metric they use for this is known as the Debt Service Coverage Ratio. In its simplicity, it wants to know that your NOI is sufficient to cover all of the mortgage payments for the year, and still have some buffer in case something happens.
Generally, the formula will go something like this:
DSCR (Debt Service Coverage Ratio) is equal to:
NOI / Annual Mortgage Payments
Let’s use the following example:
You buy a property for One million dollars, and use a loan from the bank for 75% of the purchase price. The bank lends you this money at 4% Interest for 30 years.
You payments will look like this:
Loan Amount: $750,000
Annual Payments: $42,972
Let’s assume the NOI of this property is $65,000.
What this means is that this loan will have a DSCR of 1.51
Banks typically will underwrite and want a DSCR of 1.20x at the minimum, but each lender is different. A 1.20X DSCR means that for every dollar of debt service, you will have $1.20 of NOI. This way, the bank knows that they can safely assume you will pay the mortgage.
Before you go to secure debt, make sure the in place NOI can support the debt you plan on borrowing. If not, you may need to adjust the purchase price, or take less debt, which will impact your returns.