When analyzing levered (properties you acquire using debt) assets, one of the most important metrics to look at it something known as Debt Service Coverage Ratio.
Debt Service Coverage Ratio (DSCR) is a ratio that tells you how much debt you need to service, compared to how much net operating income you are taking in.
Typically the higher the ratio, the lower the risk, and the more cushion you have to pay back your lender. In order to calculate your DSCR, you need to know your current net operating income (net income before debt service) and how much your monthly note payments will be.
Here’s an example:
Let’s say we are buying a stabilized 200 Unit apartment building for $10mm.
We have $700,000 in Net Operating Income.
We are putting down 25% equity, or $2.5mm. So we are borrowing $7.5mm.
Let’s say the terms on that money are a 25 year amortization at 5%. So our annual payment will be about $526,000.
Take your $700,000 in NOI and divide it by your total debt service of $526,000and youre DSCR is:
So for every $1.33 we take in, we are paying out a $1 in debt. For some investors this is perfectly acceptable, for others this would never work. The higher the number, the less “risky” the deal and vice versa.
DSCR is also one of the major metrics a lender will look at when analyzing your deal. Higher DSCR’s, less risk.
Just a side note, I hate high leveraged deals. Anyone who has ever owned real estate knows that sometimes “anything that can go wrong, will go wrong.” That’s why you need to model your numbers conservatively. I prefer buying an asset after a highly leveraged guy messes up.