A DSCR (debt-service coverage ratio) loan is a type of financing used by real estate investors to purchase or refinance investment properties. DSCR loans are different from conventional mortgages in that they are based on the projected cash flow of the property rather than the personal income of the borrower. For real estate investors, DSCR loans offer some unique advantages but also have some drawbacks to consider. In this article, we’ll go over the key pros and cons of DSCR loans on today’s real estate market so can determine if this type of financing is right for your next real estate investment.
What is a DSCR Loan?
So what is a DSCR Loan?. A DSCR loan is a mortgage loan that is based on the debt service coverage ratio of the property being financed. The debt service coverage ratio (DSCR) is a measure of the cash flow available to pay current debt obligations. Specifically, it’s the net operating income divided by total debt service.
For example, if a property has $100,000 in net operating income per year and $80,000 in total annual debt payments, the DSCR would be 1.25 ($100,000 divided by $80,000). The higher the DSCR, the easier it is to repay the debt each year.
Lenders want to see a DSCR of at least 1.0 or higher, which indicates there is enough income to cover the loan payments. DSCR loans allow investors to qualify based on the cash flows of the property rather than personal income or credit scores. These loans are commonly used to purchase or refinance real estate investments like apartment buildings, retail centers, self-storage units, and other types of income-producing properties.
Pros of DSCR Loans
Higher Loan Amounts
One of the biggest advantages of DSCR loans is that they allow investors to borrow higher loan amounts compared to conventional mortgages. With a conventional loan for an investment property, lenders typically limit the loan amount to 80% or less of the property value.
DSCR loans are often based on the lesser of 80% of the purchase price or appraised value, or an amount that results in a minimum DSCR of 1.0 or higher. This means investors can often qualify to borrow up to 80% or more of the property value as long as there is enough net operating income to support the debt. This allows real estate investors to leverage their money and yield higher returns.
Only Property Income Required
Another major benefit of DSCR loans is that they are based solely on the property’s income rather than the borrower’s personal income or credit score. This allows real estate investors to qualify for financing based on the performance of the investment property alone.
Traditional loans require detailed documentation of personal financials, which can disqualify investors who have experienced credit challenges or don’t have W-2 wage income. With a DSCR loan, even investors who have low credit scores or less-than-perfect credit can obtain financing as long as the property meets the lender’s DSCR requirements.
Purchase and Refinancing Options
DSCR loans can be used to either purchase or refinance investment properties. This provides flexibility for investors.
For instance, an investor may obtain a DSCR loan to tap into their property’s equity to pull cash out for other investments through a cash-out refinance. Or an investor may use a DSCR loan to purchase a new income-producing property to add to their real estate portfolio.
Non-Recourse Debt
Most DSCR loans are non-recourse loans, meaning the lender cannot pursue the borrower personally in case of default. The lender can only seize the financed property through the foreclosure process. This helps protect the investor’s other assets.
Prepayment Flexibility
Unlike most conventional mortgages, DSCR loans often don’t have strict prepayment penalties. This gives investors the flexibility to pay off the loan early or refinance into better terms in the future without incurring major fees.
Multiple Property Loans
Some lenders offer DSCR loans that allow investors to group multiple properties into one loan. This can allow you to buy several rental properties or refinance an entire real estate portfolio with just a single loan application, which can save time and effort.
Cons of DSCR Loans
While they offer some attractive benefits, DSCR loans also have some downsides to consider.
Higher Interest Rates
The main tradeoff of the looser borrowing guidelines DSCR loans offer is that the rate is higher. Typically, DSCR loans will have interest rates ranging from 7% to as high as 12% or more depending on the particulars of the deal.
The exact loan terms will depend on factors like the location, building age, tenant mix, amount of equity, and your own credit profile. But in most cases, the interest rates on DSCR loans will be notably higher than traditional fixed rate mortgage loans.
Lower Loan-to-Value (LTV) Ratio
Even though DSCR loans provide higher leverage than conventional loans, they often max out at 75% to 80% loan-to-value (LTV). With a traditional mortgage, an owner-occupant can qualify for up to 95% LTV financing.
So while the borrowing limits are higher compared to other investment loans, DSCR loans may require a slightly larger down payment from the investor’s own funds.
Tighter Debt Service Coverage Ratio Requirements
Since DSCR loans are underwritten specifically based on the DSCR ratio, lenders have very strict requirements. Many lenders want to see a DSCR of at least 1.20 or higher.
If the property’s DSCR slips below 1.0 at any time, the lender may call the note due immediately or charge a higher interest rate. So your cash flows need to substantially exceed the debt.
Shorter Loan Terms
Most DSCR loans typically come with shorter 5 to 10-year terms compared to 15 or 30-year terms for conventional home loans.
This gives investors less long-term certainty. And since the full balance comes due at maturity, refinancing may be necessary.
Scrutiny of Property Finances
To approve a DSCR loan, lenders will heavily scrutinize the property’s finances, profitability, and management. You’ll need to provide detailed documentation on past expenses, rents, maintenance costs, and upgrades.
If any aspect of the finances or property condition is less than ideal, it can jeopardize loan approval. This level of scrutiny can be challenging for some investors.
Is a DSCR Loan Right for You?
Now we have covered the DSCR loan pros and cons, we can see this type of loan product can be an excellent source of financing for real estate investors who qualify.
Here are a few key questions to ask yourself to determine if pursuing a DSCR loan makes sense:
– Do you have experience with commercial real estate investing?
– Does the property generate sufficient and predictable income to meet DSCR requirements?
– Do you need leverage beyond what conventional loans offer?
– Are you able to put down at least 20-25% as a down payment?
– Can you handle higher interest rates and shorter loan terms?
– Are you able to properly manage the property via self-management or professional property management?
– Does the property have a successful track record of strong occupancy and cash flow?
– Are you able to document the property’s financials and provide required reports to lenders?
If you answered yes to these questions, you may be a good fit to fund your next commercial real estate purchase or refinance. Just be sure to run the numbers carefully and fully understand the pros and cons before moving forward.
How Do DSCR Loans Work?
If you’re interested in obtaining a DSCR loan, here is a quick rundown of how they work:
– Find and vet potential properties, considering DSCR loan requirements
– For a purchase, calculate the maximum loan amount you can qualify for based on projected cash flows and minimum DSCR requirements
– For a refinance, calculate the maximum loan amount based on existing property income/expenses
– Find a reputable commercial lender that offers the best rates on investment properties
– Submit a full loan application documenting your financials, business history, property information, and profit and loss statements
– Provide detailed expense and income projections showing cash flow
– Allow the lender to fully evaluate property financials, conditions, etc.
– Receive and accept a formal loan offer if approved, including loan amount, interest rate, DSCR requirements, etc.
– Provide down payment funds and pay any loan origination fees
– Close on the loan and begin making monthly payments
– Submit required annual profit and loss statements and property reports to lender
As long as you can continue meeting the lender’s DSCR requirements, you’re able to hold the loan and benefit from the property cash flows. If the DSCR ratio ever slips too low, be prepared for the lender to request paydowns or additional collateral.
The Bottom Line
DSCR loans can be excellent loan programs for real estate investors to secure financing for investment properties based on property performance rather than personal finances. They provide access to leverage that may not be possible with conventional loans.
However, the higher rates, down payment, and property income requirements mean DSCR loans aren’t right for all investors or properties. By carefully weighing the pros and cons against your own investment goals and financial capabilities, you can decide if applying for a DSCR loan is the right move for your next real estate project.