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Debt Coverage Ratio
The Debt Coverage Ratio (DCR) is also known as Debt Service Coverage Ratio (DSCR). DCR measures the ability of the income generated by an investment property to cover the monthly loan repayments such as mortgages. The higher the DCR then the more income is available to cover debt service with a corresponding less risk of defaulting on loan repayments. The DCR is calculated by dividing the net operating income (NOI ) by a property's annual debt service. The formula for DCR is:
Annual debt service equals the per annum total of all interest and principal paid for all loans on a property.
A debt coverage ratio of less than 1 indicates that there is not enough cash flow to pay the property's operating expenses and have enough left over to cover its annual debt services. That is, the income generated by an investment property is insufficient to cover the loan repayments and operating expenses. For example, a DCR of 0.85 indicates a negative income. There is only enough income available after paying operating expenses for only 85% of the annual loan repayments. In contrast, an investment property with a DCR of 1.10 generates 1.10 times as much annual income as the annual debt service on the property. In other words, the investment property produces 10% more net operating income than is required to pay the operating expenses and annual loan repayments.
For example, consider an investment property with a net operating income of $30,000 and annual debt service of $25,000. The DCR for this property would be equal to 1.2. In other words the property generates 20% more annual net operating income than is required to cover the annual mortgage payment amount.
Many banks and other lenders require a certain level of DCR before they approve a loan for an investment property.