Thursday, November 12, 2015

Positive Cash Flow = Positive Debt Coverage Ratio (DCR)

After you determine an income property yields a POSITIVE CASH FLOW, the next step is to calculate the property’s ability to service mortgage financing costs out of this cash flow.

The standard measurement within the investing world is referred to as the DEBT COVERAGE RATIO (DCR). DCR is simply comparing the property’s net operating income (NOI) to the projected mortgage financing costs – typically on both a monthly and annual basis.

Banks/Lenders typically look at DCR closely, wanting to confirm that the cash flow is sufficient to cover the related debt cost (aka monthly mortgage payment). In fact, most often they are looking to see a positive margin, which exceeds the mortgage servicing costs.

Source: Politico

Using a ‘break –even’ analogy, if the cash flow just meets the debt service costs - this would be a simple ‘break even’ outcome.

Consider the following illustration:

Property 1 
Net Operating Income - $75000
Mortgage Costs (Debt) - $50,000
DCR – 1.5

Property 2
Net Operating Income - $45,000
Mortgage Costs - $50,000
DCR - .9

*All $ amounts are annual

In the case of property 1, the cash flow exceeds the funds required to cover the mortgage requirement. In the case of property 2, a deficit is created ($5,000) which is not only an annual loss, but creates a negative return on actual cash invested.

In layman’s terms, a DCR of (1) is a ‘break-even’ - a DCR of (1.5) is ‘positive’ - a DCR of (.9) is ‘negative’. For investment purposes, this is how you should approach your analysis.

Just a final word on the bankers/lenders, you’re ability to negotiate favourable mortgage terms are clearly impacted by the property’s DCR. This gives you some insight as to how they evaluate risk in underwriting mortgages and how it ultimately impacts your proposed purchase.

How are lenders approaching DCR in your area? How does it affect rates offered and other terms proposed? 

Feel free to reach out to us, should you have interest in the Windsor-Essex market. As always, appreciate any feedback in the comments!

Mark Lalovich
Office: (519) 966-0444
Cell: (519) 259-5434

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