DSCR Calculation
The DSCR calculation is a straightforward formula used to assess the subject investment property’s capacity to generate enough rental income to cover its monthly debt obligations. This calculation is used specifically for DSCR loans, which are tailored for investment properties and do not require borrower employment or personal income documentation.
Here is a comprehensive breakdown of how the DSCR is calculated, drawing directly from the sources:
The DSCR Calculation Formula
The Debt Service Coverage Ratio (DSCR) is calculated by dividing the gross rental income generated by the property by the total proposed monthly debt service (PITIA or ITIA).
DSCR = Gross Rents / Proposed PITIA (or ITIA)
Example: Rents of $1,000 divided by a PITIA of $800 results in a DSCR of 1.25. This indicates the property generates 25% more income than necessary to repay the loan.
Components of the DSCR Calculation
- Gross Rents (The Numerator)
The “Gross Rents” used in the DSCR calculation must be determined through various documentation methods, often seeking the most conservative figure.- Source of Rent: The source of rental income must be documented using the appraiser’s opinion of market rent (FNMA Form 1007 or 1025) and/or an executed lease agreement.
- Long-Term Rentals (LTR): For purchase transactions, 100% of the market rents as determined by the appraiser is used. If an existing lease is in place, the lesser of the lease or the appraiser’s market rent will be utilized, except in certain cases where a slightly higher lease can be used if confirmed by rent receipts.
- Short-Term Rentals (STR): For purchase transactions using STR income, specialized tools like AirDNA Rentalizer may be required. For our Edge DSCR, 80% of the estimated gross receipts is used to determine the qualifying rental income, and typically a vacancy/expense factor of 25% applies to the DSCR calculation. For our Horizon DSCR, the minimum DSCR for STRs is higher (1.15).
- Vacant Properties: For purchase transactions, it is generally acceptable for the property to be vacant, and gross market rents from the appraisal forms (1007/1025) will be used.
- Proposed Debt Service (The Denominator)
The debt service is calculated based on the total monthly obligations related to the subject property, collectively known as PITIA or ITIA.- PITIA: Stands for Principal, Interest, Taxes, Insurance, and Association Dues (if applicable).
- ITIA (Interest-Only): If the loan has an interest-only (IO) feature, the DSCR can be calculated using the Interest-Only payment plus Taxes, Insurance, and HOA dues.
- IO Qualification: DSCR loans are eligible to qualify the DSCR based on the interest-only payment (ITIA). For our Connect, using the interest-only payment for DSCR calculation is eligible if the LTV does not exceed 75%. If the LTV exceeds 75%, the DSCR must be calculated based on the fully-amortized payment (PITIA).
- Amortizing Loans: If the loan is fully amortizing, the payment used is the Principal and Interest (P&I) payment.
- Payment Basis: The taxes, insurance, and HOA fees must be verified and converted into a monthly payment.
Key Concepts in DSCR Determination
- Purpose: DSCR loans are solely for investment properties and are considered “business purpose loans,” exempting them from the federal Ability-to-Repay (ATR) rule and Debt-to-Income (DTI) calculation requirements.
- DSCR Thresholds: A DSCR above 1.0 indicates positive cash flow and means the property generates more income than required for the debt service. A DSCR below 1.0 indicates the property has negative cash flow.
- Minimum DSCR: The minimum required DSCR varies by lender and risk profile, but can range from 0.75 up to 1.1x or 1.2x.
- Expenses Not Included: Lenders do not factor in expenses such as management, maintenance, utilities, repairs, or a general vacancy rate into the DSCR calculation, though a vacancy factor may be applied to the gross rent calculation in certain short-term rental scenarios.
*Note on Qualifying Payment: Even if a 40-year Interest Only loan has a 10-year IO period, DSCR loans may be qualified using the Interest Only payment (ITIA). However, if the DSCR loan is less than 5 years, the DSCR is calculated based on the fully amortized PITIA payment.
FAQ's
A DSCR ratio under 1.0 indicates negative cash flow, meaning the property is losing money relative to its debt obligations. While a DSCR below 1.0 increases the lender’s risk, some lenders will still approve loans down to a minimum ratio of 0.75.
Yes, borrowers with a better DSCR ratio can generally secure more beneficial interest rates and terms on their loans. Conversely, a DSCR ratio of less than 0.75 requires a larger down payment/equity and more reserves to offset the negative cash flow.
The gross rent utilized in the DSCR calculation is typically the lesser of the executed lease agreement or the market rent determined by the appraiser. This conservative approach helps the lender mitigate risk.
DSCR loans are specifically tailored for investment properties. The loan must be for a business purpose, and the DSCR loan affidavit requires that the borrower cannot occupy the property.
Yes, DSCR loans are eligible to qualify the DSCR based on the Interest-Only payment (ITIA). However, for one program, if the LTV exceeds 75%, the DSCR must be calculated based on the higher, fully amortized payment (PITIA).
For DSCR calculation purposes, the lender does not take into account operational expenses such as management, maintenance, utilities, repairs, or a general vacancy rate. Only property taxes, insurance, and association dues are included in the expense portion of the ratio.
The property’s potential rental income is typically documented by the appraiser’s comparable rent schedule using FNMA Form 1007 or 1025. This market rent is crucial, as the qualification for DSCR loans is based on the cash flow from the subject property.
A DSCR ratio above 1.0 indicates that the property generates positive cash flow. This means the property earns more income than is necessary to repay the loan’s debt obligations.
PITIA represents the annual mortgage debt obligations of the property. The acronym stands for Principal, Interest, Taxes, Insurance, and Association Dues (if applicable).
The DSCR is calculated by taking the property’s Gross Rental Income and dividing it by the Proposed PITIA. For loans with an Interest-Only feature, the DSCR can be calculated using the gross rent divided by the ITIA (Interest, Taxes, Insurance, and Association Dues).
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