How do rising interest rates affect DSCR Loans?

The Debt Service Coverage Ratio (abbreviated “DSCR”) is commonly used by private lenders who underwrite asset based loans for real estate investors. DSCR measures a property’s ability to repay its debt (without relying on the borrowers personal income) after accounting for property expenses. Specifically, asset based lenders want to ensure that a property has enough net income to cover the mortgage payment. The DSCR is calculated by evaluating the following variables:

where Net Operating Income (NOI) = (Gross Rents) less (Taxes, Insurance, and Other Expenses)
where Total Debt Service = Annual Mortgage Cost (excluding Taxes, Insurance, and Other Expenses)

Calculating this ratio will help understand how the net income compares to the mortgage costs, and is commonly expressed as a ratio. If NOI is greater than Total Debt Service, the ratio would be greater than 1.00 (ie: a 1.40X DSCR ratio means that the property has 140% the net income versus the mortgage cost). If NOI is less than Total Debt Service, the ratio would be less than 1.00 (ie: a 0.90X DSCR ratio means that the property has 90% the net income versus the mortgage cost).

Let’s look at the following example for a small single family rental property with the following characteristics:

• Property Value $125,000

• Loan Amount $100,000 (80% LTV)

• Monthly Rents $800

• Annual Property Taxes $1,250

• Annual Insurance $1,000

Based on the above figures, we can calculate the Net Operating Income (NOI) to be:
(Gross Rents) less (Taxes, Insurance, and Other Expenses)
($800 x 12) less ($1,250 + $1,000) = $7,350 (NOI)

The property’s NOI is not affected by a change in interest rates, but let’s look at how interest rates affect this property’s ability to cover the mortgage payment by calculating the DSCR with varying rates:

• Based on a 4.00% rate on a 30 year fully amortized mortgage, the monthly principal and interest payment is $477.42 per month (or $5,729.04 per year).
  We can clearly see that the property’s net income ($7,350.00) is enough to coverage the annual mortgage cost ($5,729.04). But to look at the specific calculation, the DSCR for this mortgage structure is = NOI / Total Debt Service = ($7,350.00) / ($5,729.04) = 1.28X
  Said another way, the property has 1.28 times the net income compared to the mortgage cost.

• Based on a 6.00% rate on a 30 year fully amortized mortgage, the monthly principal and interest payment is $599.55 per month (or $7,194.60 per year).
  We can clearly see that the property’s net income ($7,350.00) is barely above the annual mortgage cost ($7,194.60). But to look at the specific calculation, the DSCR for this mortgage structure is = NOI / Total Debt Service = ($7,350.00) / ($7,194.60) = 1.02X
  Said another way, the property has 1.02 times the net income compared to the mortgage cost.

Most private lenders have a minimum DSCR requirement, with the objective of having confidence that the property can generate enough cash flow to keep the mortgage current. Typically, the minimum DSCR for private lenders is 1.10X. Keep in mind, the DSCR calculation doesn’t account for all property expenses (such as property repairs and maintenance, property management, vacancy, etc) for small residential properties (1-4 Units). However, multifamily/commercial property appraisals heavily rely on coming up with a property value that is heavily influenced by a property’s NOI, so do include the “Other Expenses” as mentioned above.

The above examples show how higher interest rates (due to the interest rate environment, credit worthiness of the borrower, or other factors) can drastically increase a mortgage payment, and affect a property’s ability to meet the DSCR requirements of asset based lenders.

Carlyle Capital is a direct private lender that offers DSCR loans for residential, multifamily, and commercial properties, and works closely with borrowers in all situations to come up with a solution for their borrowing needs.