Wednesday, February 6, 2013

Rental Property Investing - Debt Coverage Ratios (DCR)

Since leverage involves debt, let’s discuss how we analyze the debt relative to the property’s cash flow. The standard measurement within the investing world, is referred to as the Debt Coverage Ratio (DCR). The math is pretty straightforward –the ratio measures the property’s net cash flow divided by the annual mortgage costs.

Consider the following examples:

Property 1                                                   Property 2
Net Operating Income - $75,000                Net Operating Income - $45,000
Mortgage Costs (Debt) –$50,000               Mortgage Costs (Debt) - $50,000
DCR – 1.5                                               DCR – 0.9

  • All Dollar Amounts are annual

Now in the case of Property 1, the cash flow comfortably covers the mortgage requirement with a residual leftover (AKA –return on cash invested). With Property 2, a deficit is created (of $5000), which in essence becomes an annual loss and generates a negative return on your cash invested.

The significance of this exercise becomes really clear once you look to arrange mortgage financing in either case. The 1.5 DCR will receive good support with the Commercial Mortgage lenders, as the cash flow of the property provides a cushion against the mortgaging costs you will be incurring. However in the case of the 0.9 DCR, the deficit will raise red flags with Commercial Mortgage lenders and certainly fall outside of their normal guidelines.

Standards will vary from area to area and lender to lender, in terms of DCR ratios required. But more importantly, it must fit with your own objectives for investing and in considering viable rental property options.

Again, seek out experienced commercial realtors within your market to assist in searching out rental properties with positive DCR(s).

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