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What is DSCR (Debt Service Coverage Ratio) Financing and How Can I Use it to Expand my Portfolio

If you’re looking to level up in 2023 and expand your portfolio by making smart real estate investments, you should probably know more about DSCR financing options and how they can boost your buying power.

This is an alternative to conventional or agency financing, and it’s based on a property’s Debt Service Coverage Ratio (DSCR), which is a measurement of the property’s ability to generate enough income to cover all debt payments. 

Unlike traditional mortgages, a DSCR loan is not dependent on a buyer’s personal ability to repay (also known as a non-qualified mortgage, or “no-income-doc” mortgage), which can make them an excellent tool for hopeful investors.

Let’s take a closer look at the bigger picture of buying a property with DSCR funding and explore the benefits and drawbacks of this type of financing for real estate investors.

More on the Metrics

Simply put, the DSCR is one of the many calculations lenders use to determine the maximum amount a real estate investor can qualify for when applying for a new loan or a refinance. 

The concepts behind DSCR financing are pretty straightforward. Before a real estate asset is purchased, the prospective lender will determine the property’s profitability and whether it generates enough revenue to cover its debt payments. This calculation is based on the property’s net operating income (NOI) and its debt service (the amount of money required to pay the property’s mortgage and other debts). 

Getting to an accurate NOI is crucial — an overinflated number that neglects to factor in vacancy rates or a miscalculation that results in an artificially low metric can skew your capitalization rate and possibly lead to a bad investment. 

DSCR formula:

Debt Service Coverage Ratio = Net Operating Income / Debt Service

If the property’s DSCR is less than 1, it means there’s negative cash flow and the property is not generating enough income to cover its debt payments. In this case, the lender probably won’t approve the loan unless the investor provides additional collateral or a higher down payment to secure the loan (thereby improving that ratio anyway.)

If the DSCR is higher than 1, it means that the property is generating enough income to cover its debt payments and the repayment ability is favorable. In this case, the lender will likely give the go-ahead for the investor to purchase the property. Typically, having a DSCR of 1.1 to 1.4 is the sweet spot, depending on the asset class. 

Pros and Cons

There are several boons to DSCR financing for real estate investors. The first thing to note is that these types of loans are often more flexible than regular residential financing. 

The underwriter puts far more weight on the property’s ability to generate income when deciding whether to approve the loan. This means that investors with properties that have promising rental income potential may be able to obtain financing even if they don’t have perfect credit or already have a high (personal) DTI ratio.

Second, DSCR funding can be more affordable. Because the lender is using the property’s income to determine the loan amount, investors may be able to obtain larger mortgages with somewhat lower interest rates (it’s worth noting that this can go the other way too – in many cases the rate can be higher than conventional financing.) This can make it easier for investors to purchase real estate that would otherwise be out of their price range.

Third, DSCR financing can provide investors with more stable and predictable cash flows. Because the amount of the loan is based on the property’s income, investors can be relatively confident that their monthly mortgage payments will be entirely covered by the property’s rental income. This can provide investors with a greater sense of security and help them to plan for increasing their holdings in the future.

Despite these benefits, there are also some drawbacks to this strategy, so it pays to do plenty of research before making the final decision. Overcommitting yourself can derail your investment plans and lead to defaulting on your payments.

DSCR loans can be more difficult to obtain than a standard mortgage because the lender is taking on a bigger risk by basing the issued amount solely on the property’s income without factoring in the buyer’s history or creditworthiness.

Lenders are vastly more selective about the properties they finance this way, making it harder for investors to find organizations that are willing to provide DSCR financing.

This path can be more expensive than the conventional route. Because your NOI can shift due to vacancies and other factors, lenders may charge higher interest rates or require larger down payments. This can make DSCR financing less attainable for some investors, especially those just starting out.

Get the Answers You Need

Sourcing an ideal property with a high enough DSCR can be quite challenging. That’s why it’s vital to work with an experienced and proactive real estate team — including a lender who’s familiar with this unique market.

Buying investment property in the Chicagoland area could be your crucible for generating wealth, but every such initiative comes with some risk. Partnering with a mortgage broker who has in-depth knowledge of the local landscape gives you the opportunity to explore a wide range of financing options and find the right loan product to help grow your investment portfolio.

If you’re interested in learning more about DSCR loans or other alternative financing solutions for real estate investing, reach out today to schedule a one-on-one consultation. 

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