The most important ratio to understand when making income property loans is the Debt Service ratio. The debt service ratio is used by the lender to determine how well the investment will pay for itself, or how risky the investment may be. This ratio is calculated by dividing the Net Operating Income (NOI) by the Total Debt Service.
Net Operating Income (NOI) is the income from a rental property less all operating expenses. The lender will insist on including a percentage of gross rents as operating expenses to cover the vacancy factor and collection loss. The lender will also insist on including a small percentage of gross rents to cover the costs associated with managing the investment property in the event of a borrower default. Examples of operating expenses are, but may not be limited to:
- Vacancy & Collection Loss
- Real Estate Taxes
- Repairs & Maintenance
Note that loan payments on commercial loans are not included in operating expenses, they are already included in the Total Debt Service calculation.
The Total Debt Service includes the principle and interest payments (P&I) of all loans on the property, not just the first mortgage. Real estate taxes and insurances are not included as they are already included in the Net Operating Income calculation.
To determine the Debt Service Coverage Ratio divide the Net Operating Income (NOI) by the Total Debt Service. The higher the ratio the more net operating income is available to pay off (service) the debt. The lender wants this ratio to be as high as possible and may establish a target guideline to aid in its analysis of the loan.
A Debt Service Coverage Ratio of 1.00 is considered “break even” as the Net Operating Income is just enough to cover the debt service. A ratio less than 1.00 would indicate a negative cash flow and the borrower would then have to pay for normal operating expenses from other funds. Although lenders generally frown on negative cash flows the borrower may have sufficient compensating factors (i.e. very low LTV, high outside income, relatively low negative cash flow) to justify approval of the loan.