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How To Use Debt Service Coverage Ratio | What Are DSCR Terms Explained With Examples - YouTube
Channel: Trevor Calton
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Hi, this is Trevor and today we're
talking about Debt Service Coverage Ratio.
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DSCR is an underwriting term used
by lenders that effectively sets a
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minimum for the amount of net operating
income available to cover the debt service.
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The ratio is often set right
around 1.25... Sometimes it's 1.2, sometimes
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it is 1.3. It depends on the industry, the
market, the market timing, and the product type.
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Debt service coverage ratio tells
us how much extra cushion we need to
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have in our net operating income over
the debt service or the annual loan payments.
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In this case, a 1.25 debt
service coverage ratio means that the
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NOI needs to be 125% or 1.25 times the amount of the annual loan payments.
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Debt service coverage ratio
sets a limit on how much risk the lender
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is going to take in terms of what they
loan compared to the cash flow on the property.
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They don't want to put
borrowers in a position where they have
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barely enough net income to cover the
debt service, or even worse, not enough
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net income. So the debt service coverage
ratio builds in the amount of cushion
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that they want. Lenders can adjust this
for competitive reasons or market
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reasons, but it typically is about 0.25
over the debt service amount.
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So let's take a look at an example. Imagine a property has $100,000 of net operating income.
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Well, if we look at our
formula, if 1.25 is our minimum ratio,
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that means that 1.25 equals $100,000
divided by X, and would make X = $80,000. So this
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makes $80,000 our maximum annual
debt service. So we take that number, we
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divide it by 12, and we know that our
maximum monthly loan payment is going to be $6667.
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So understanding this, if the debt
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service coverage ratio dictates what our
maximum loan payment can be, then one
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thing that we need to recognize is that
our debt service amount that is allowed
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by the lender is capped at $6667. If
interest rates go up, the payment cannot
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go up beyond that. So if interest rates
rise, then the loan amount would have to
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go down, in order for us to stay
within the minimum required debt
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service coverage ratio. Let's look at the
numbers behind that. So if we've already
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determined that our debt service
coverage ratio is a minimum of 1.25 and
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we have $100,000 in
net income, then we know that X, which in
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this case would be $80,000 is
our maximum debt service per year, or
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$6667 per month. Let me show you how this would be calculated in the face of
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changing interest rates, or perhaps a
shorter amortization period. I'm going to
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lay this out the way we would lay it out
in a financial calculator. if you haven't
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taken that lesson yet just check out our
other videos on financial calculators,
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calculating debt service, present
value, etc. So let's imagine we're
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punching this into our financial
calculator. In this example, I'm going to
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use a 30-year fixed loan with monthly
payments at 6% fully amortizing.
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So here's what we've determined - we've
determined that our maximum loan payment
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each month can only be $6667. If we have a 6% interest rate and we're doing a
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30-year or 360 month amortization, we get
a $1,112,000
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maximum potential loan.
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Typically, if our net operating income is fixed, then our maximum loan payment is also fixed.
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If interest rates in this case should go
up to 7%, still amortized over
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30 years, and knowing that our payment
can't go up this would bring our maximum
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loan amount to $1 million.
Similarly, if we still had a 7% interest
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rate but our amortization was shortened
to, say, 25 years or 300 months, and our
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payment's still capped at $6667, then our
loan amount would be reduced even
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further to $943,000. So debt service
coverage ratio, again, tells us what the
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percentage of the net operating income
over the debt annual debt service needs
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to be, and as we can see, annual debt
service can be affected by both interest
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rates and amortization. Most importantly,
what we need to remember here is debt
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service coverage ratio lets us know how
much extra net operating income we have
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over our loan payments. This has been an
overview on debt service coverage ratio.
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Thanks for watching!
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