Real estate investors take time to properly determine whether a particular property is a good investment. There are multiple factors to consider when investing in real estate which is where the debt service coverage ratio comes into play. After all, real estate isn’t the most liquid of investments.
Common Ways to Evaluate Property
The first thing to consider is of course the price of the property. That’s relatively easy to evaluate by comparing recent sales of similar properties in the area. How long does it take to sell a home?
This “days on market” number tells an investor if the area is booming or in a bust mode. If a home typically sells within 60 days, it’s considered a seller’s market where top dollar is typically commanded. For someone who anticipates buying and selling quickly, or flipping, this is a major consideration. But for real estate investors who are looking for the long term, other factors must be reviewed.
Does the property cash flow? In other words, does the market rent for the area enough to cover the mortgage payment, taxes, insurance and expenses? If not, the investor will typically move on to another property. If it does cash flow, how much profit is there? If the principal and interest, taxes and insurance (PITI) is $1,000 and market rent if $1,200, that leaves $200 in monthly income for the investor. Anything less than $1,000 that makes the property an expense, not income.
Is the property in good shape? Does it need any repairs or maintenance? If so, those expenses must be measured as well. A rental property might be listed for $300,000 but needs an additional $50,000 of work. If the property is in excellent condition not only will it appraise well but it indicates the current owners have taken care of the home and addressed any issues as they came about. But there is another number investors look at. It’s a ratio of income compared to debt service. In other words, the debt service ratio.
Debt Service Coverage Ratio Explained
Debt service is simply the mortgage payments made to the lender. Debt service is calculated by dividing the net operating income from the unit by the mortgage payments. Anything above 1.00 means the property cash flows. Ideally, real estate investors want to see the debt service coverage ratio be closer to 1.25. If the rental property generates $100,000 in revenue and the mortgage payments are $80,000 the DSCR is then 1.25.
The debt service coverage ratio (DSCR) is impacted by interest rates as well as the current rental market and is relatively easy to calculate. If a particular property is in good condition, cash flows and the DSCR is 1.25 or better, the real estate investor will more than likely purchase the property. When an investor makes an offer on a home and applies for a new loan, the lender orders a property appraisal.
The appraisal will research and record recent sales of similar homes in the area to support the new purchase price. At the same time, the appraiser will complete a market rent survey which will show how much the property would likely rent for. The DSCR will show not just if the property cash flows each month but how much cash will be generated compared to the expenses of owing the home.