Today, we’re covering the topic of DSCR Loans. As you know all residential real estate investors look for easy access to capital at the highest leverage to better scale their portfolios.
The plan for these investors is to locate value-add properties from motivated sellers. When renovations are complete, the investment property can be either sold at a profit or refinanced for the buy-and-hold objective.
A private lender offering DSCR (debt service coverage ratio) loans is the source of capital that meets the investors’ expectations when a property is stabilized (i.e. rented). A DSCR loan is the private lender’s alternative to the permanent financing offered by traditional lenders.
This article will explain the structure of a DSCR loan for real estate investors to consider for long-term permanent financing.
Key Takeaways
- A DSCR loan is an alternative a private lender offers for long-term permanent financing
- The debt service coverage ratio and the borrower’s credit score are the primary determining factors for determining loan terms
- A DSCR measures a property’s ability to generate enough cash to cover monthly expenses
Defined Terms
- Net Operating Income (NOI) – the remaining cash after deducting a property’s operating expenses from the collected rent
- Cash Flow – the net cash after deducting mortgage payments and reserve deposits from the NOI
- Debt Service Coverage Ratio – the ratio of a property’s rental income to the debt service and other expenses (i.e. property insurance, tax, and HOA fee, if any)
- Loan-To-Value (LTV) – the ratio between the loan amount and the property’s after-renovation value (if rehabed) or as-is value
- Stabilization – occurs when a property generates a sufficient amount of income to cover the operating expenses, loan payments, and fund reserve accounts without an additional cash injection
- PITIA – Principal, Interest, Taxes, Insurance, and Association Fee (HOA)
- Traditional Lender – banks, credit unions, and other capital sources insured by the FDIC
DSCR vs. Traditional Long-Term Financing
A DSCR loan provides a real estate investor with a viable alternative to a permanent loan at stabilization.
Short-term, hard-money loans are used to acquire a value-add opportunity and fund the renovations. When the property stabilizes, these loans are typically refinanced with long-term permanent financing offered by traditional lenders.
These loan structures provide lower rates and fees than short-term loans, but the LTV ratios are lower and investors need to qualify.
Traditional lenders cannot be flexible in their underwriting because they are heavily regulated to do so. This means the investors must fit in “the box” with a high W-2 wage, excellent credit scores, and high liquidity. The “box” of the traditional lender is set by Fannie and Freddie in the secondary markets when the loan is sold.
The experienced investor knows that the rates and terms advertised by traditional lenders are targeted for owner-occupied homes. The terms and rates offered to an investor are higher and less competitive.
That being said, the DSCR loan alternative could be a viable option for an investor to consider. A DSCR loan is a long-term loan for permanent financing when a property is stabilized. This loan platform allows the investor to “cash out” the equity created by the renovations.
The private lenders offering DSCR loans are flexible in terms, qualifications, and underwriting targets. These private lenders apply the same entrepreneurial spirit to DSCR loans as to short-term hard-money loans. The time between application and closing is shorter and the qualifications could be more rigorous.
The Stabilized Property
The basis for the underwriting of a DSCR loan is the property’s performance. The loan terms are based on the cash flow.
The NOI is just as described. It is the remaining cash after operating expenses are deducted from the collected rent. Operating expenses are the utilities, property taxes, insurance premiums, repairs, and any other expenses necessary for the property’s operation.
An important note, though, is that mortgage payments are not considered an operating expense. The debt service (or the mortgage payment) and the funding of any capital or operating reserve accounts are deducted from the NOI to calculate the cash flow.
The DSCR measures a property’s ability to service the mortgage solely from operations without any additional cash injections from the investor.
What is Debt Service Coverage Ratio?
The formula to calculate this ratio is:
- Property’s Monthly Rental Income ÷ Total Monthly PITIA
As an example, if the monthly PITIA is $1,000, and the monthly rental income generated by a property is $1,200, then the DSCR for this investment is 1.20X.
A ratio of 1.2 means that the property is generating $1.20 for every $1.00 of debt service.
A lender looks to this ratio to determine if the property can sustain the loan payments. For clarification, an investor needs to understand that “debt service” is not always just the total of the principal and interest. It is the total loan payment.
Suppose the loan terms require the borrower to fund escrow accounts for property taxes, insurance premiums, and homeowner association dues. In that case, these escrow payments are a part of the debt service and must be included in the calculation for the DSCR.
A lender may require a borrower to maintain escrow accounts for all expenses superior to its loan and protect its collateral. Property taxes and homeowner association dues are superior to a mortgage, and a lender must ensure these expenses are paid. The premiums for property insurance are escrowed to ensure the policy remains in place during the loan term.
All escrowed expenses must be removed from the operating expenses when calculating the NOI to avoid being deducted twice. In other words, if there are no loan requirements for any escrowed funds, these items become operating expenses to be deducted from the collected gross rents.
The DSCR Loan Terms
The terms of a DSCR loan are largely predicated on a property’s coverage ratio and the borrower’s credit score. To a lesser extent, some other factors are also at play:
- Property type – Condo and 2-4 units tend to have a higher interest rate than a single-family house
- Loan purpose – Cash-out refinance is subject to a higher interest rate than purchase and Rate & Term refinance
- Loan amount – Not too small or not too big a loan amount is optimal in getting a desirable interest rate
- Prepayment Penalty Period (PPP) – The longer the PPP, the lower the interest rate
- Liquidity – needs to be considered in case the property becomes vacant at any time during the loan term. The borrower will need sufficient liquidity to service the loan during any vacancy
Private lenders do not publish terms in detail for their offered loans because the parameters are tailored to each borrower. Generally, for purposes of a quick calculation for an idea of a possible loan amount and rate, a competitive interest rate will need a credit score higher than 720. The LTV, or the leverage, will play a role in determining an interest rate by the DSCR and the credit score.
In general, the higher the DSCR, the higher the max leverage. A higher LTV will enable the investor to pull more from the created equity to fund a down payment on the next investment.
All lenders will have their parameters set for ratios, leverage, and interest rates. However, it is safe to say that, the closer a property is to a break-even ratio, or a DSCR of 1.0, the riskier the investment for the lender. The measurement of risk will be reflected in the quoted loan terms.
The Advantages of a DSCR Loan
This loan structure offered by a private lender will often have a higher LTV ratio. This will enable the investor to pull out more cash from the property. The borrowing entity can be an LLC, an S-corp., or any other pass-through entity typical for an investor to hold title.
Compared to traditional lenders, often a private lender does not consider itself over-exposed to a certain product type or borrower. Often, investors experience these limitations when seeking permanent financing from conventional lenders.
In addition, there is no requirement for providing tax returns or evidence of income as the underwriting is considerably based on the real estate property’s ability to generate cash flow. The borrower is not subjected to the debt-to-income ratio either, which means the borrower can keep going to expand the rental portfolio as long as each property’s numbers make sense.
The Pros and Cons of a DSCR Loan
All things have pros and cons, and mortgage loans are no exception. A DSCR loan provides a residential real estate investor with easy access to credit because the central premise is a property’s performance.
Most investors prefer using the property as the primary consideration for a loan qualification rather than their personal credit and wage information. A DSCR loan meets these objectives.
Timing is of the essence in property investment. The approval time of a private lender is shorter. The quicker the time between application, approval, and closing will sooner release the investor from the high carrying costs of the short-term loan in place.
However, unlike a short-term loan, the qualifications are specific and weighted to the DSCR for a competitive rate and a higher LTV. There is the possibility for an interest rate and the required equity to be higher than what could be quoted by a traditional lender.
Private lenders continue to add creative loan platforms for investors to consider, and a DSCR loan is a viable alternative to permanent financing offered by traditional lenders.
