When leveraging multifamily real estate, keep the debt service coverage ratio (DSCR) in mind. My last article discussed how the best real estate investments reduce risk by paying attention to break-even occupancy. Debt service coverage ratio (DSCR), also known as debt coverage ratio (DCR), is another safety number you should be aware of.
Mathematically speaking, debt service coverage ratio is defined as:
DSCR = Net Operating Income (NOI) / Total Debt Service (annual mortgage payment)
In other words, DSCR is a mathematical expression of how many times the income will cover the principal and interest mortgage payment. A DSCR of 1.00 is the break-even point. Anything under 1.00 represents negative cash-flow.
To conform to current Fannie Mae underwriting standards, DSCR must be no lower than 1.25 in high quality markets to obtain their lending. In lower tier markets, Fannie Mae will require higher debt service coverage ratios.
Obviously the higher the DSCR is, the safer the deal and more cash-flow for the investors. While initial DSCR is important, it is also important to look at how it trends over time. To make money in real estate and experience accelerated financial growth, the multifamily investor should consider rent growth in conjunction with DSCR.
Take for example, two different multifamily properties in two different markets. Both hypothetical properties have identical gross operating incomes of $1,000,000, identical expense growth of 2% per year, and identical annual debt service payments of $400,000. The first property enjoys 6% annual rent growth, while the second one is less at 2%. However, the first property has higher operating expenses than the lower rent growth property.
| Year 1 | Year 2 | Year 3 | Year 4 | Year 5 | ||
| GOI 6% | $1,000,000 | $1,060,000 | $1,123,600 | $1,191,016 | $1,262,477 | |
| GOI 2% | $1,000,000 | $1,020,000 | $1,040,400 | $1,061,208 | $1,082,432 | |
| Op Ex 6% | $500,000 | $510,000 | $520,200 | $530,604 | $541,216 | |
| Op Ex 2% | $450,000 | $459,000 | $468,180 | $477,544 | $487,095 | |
| NOI 6% | $500,000 | $550,000 | $603,400 | $660,412 | $721,261 | |
| NOI 2% | $550,000 | $561,000 | $572,220 | $583,664 | $595,337 | |
| DSCR 6% | 1.25 | 1.38 | 1.51 | 1.65 | 1.80 | |
| DSCR 2% | 1.38 | 1.40 | 1.43 | 1.46 | 1.49 |
Notice that in year one, the debt service coverage ratio is higher for the second property. However by year 2, these properties almost equalize their DSCR. The higher rent growth, higher operating expense property is the clear winner by year 3. While both properties could make great investments, it is important to consider how rent growth can affect DSCR over time.
Multifamily real estate in the right markets with the right management has a long history of creating wealth and prosperity for its owners. Over the past few years, this incredible asset class has even become better. It is full steam ahead as the population dynamics will favor multifamily for years to come. Despite this fact, it is prudent for the multifamily investor to know the safety numbers associated with this asset class.
P.S. The best real estate investments create financial growth and prosperity for the multifamily investor by insuring that the debt service coverage ratio (DSCR) is safe and rapidly growing.
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