Understanding Debt Coverage Ratio

A debt coverage ratio, also known as the debt service coverage ratio, is a popular benchmark used in the measurement of an income-producing property’s ability to produce enough revenue to cover its monthly mortgage payments. To calculate a property’s debt coverage ratio, you first need to determine the property’s net operating income. To do this you must take the property’s total income and deduct any vacancy amounts and all operating expenses. Then take the net operating income and divide it by the property’s annual debt service, which is the total amount of all interest and principal paid on all of the property’s loans throughout the year.

If a property has a debt coverage ratio of less than one, the income that property generates is not enough to cover the mortgage payments and the property’s operating expenses. A property with a debt coverage ratio of .8 only generates enough income to pay for 80 percent of the yearly debt payments. However, if a property has a debt coverage ratio of more than 1, the property does generate enough revenue to cover annual debt payments. For example, a property with a debt coverage ratio of 1.5 generates enough income to pay all of the annual debt expenses, all of the operating expenses and actually generates fifty percent more income than is required to pay these bills.

Let’s say Mr. Jones is looking at an investment property with a net operating income of $50,000 and an annual debt service of $30,000. The debt coverage ratio for this property would be 1.2 percent and Mr. Jones would know the property generates 20 percent more than is required to pay the annual mortgage payment.

If you want to purchase an income property, chances are your lender is going to require a minimum debt coverage ratio. The debt coverage ratio allows the lender to see if a property generates enough income to cover the property’s operating expenses and debt service. To a lender the higher the debt coverage ratio, the less risk there will be with the investment. Debt coverage ratio requirements vary from lender to lender with some being as low as 1.1 and others charging as much as 1.35. Most lenders will accept a debt coverage ratio of 1.2 or above.
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Article by Yon Olson, President of Accelerated Capital, Inc. – A Bend Oregon loan and mortgage company specializing in home and commercial real estate loans for all credit types. Call Yon at 541.617.0876 or visit us online for your Bend Oregon mortgage http://www.acc-cap.com/