How to choose the target DSCR for your rental property investment

by Dana Wasson/Lima One16 Dec 2019

by Dana Wasson

One of the most important metrics a rental property must know is your debt service coverage ratio, or DSCR. Your DSCR can determine whether you get financing for a property in the first place, and it will definitely determine whether your investment will be successful over the long term. So it’s vital that you know your DSCR in order to properly evaluate the profit potential, as well as risk, of your investment in a single-family rental (SFR) or multifamily property.

DSCR Basics

DSCR compares your rental income to expenses. These costs of course include both the principal payments and interest of your SFR property loan. It also includes recurring expenses such as property taxes, HOA fees, and insurance.

PITIA, an acronym for property, interest, taxes, insurance, association, is often used as the denominator in the DSCR calculation. Divide the monthly rental income by PITIA, and you get DSCR.

Sample:

  • Quadplex brings in $2,500/month across 4 units.
  • Loan (principal on property plus interest) is $1,500/month.
  • Property insurance and other insurance (flood insurance, for example) is $300/month.
  • Taxes are $300/month.
  • Association fees are $150/month.
  • PITIA equals $2,250/month.
  • DSCR equals $2,500/$2,250, or 1.11

What’s a good number for DSCR?

Your DSCR should be at least 1. If it’s not, then your rental income is less than the cost of PITIA, and you’re losing money on a monthly basis. Unless you’re getting some crazy appreciation in terms of property value, that’s a deal you should probably avoid.

In the example above, if PITIA totals $2,750, then your DSCR would be 0.91, and you would be losing $250/month.

If you have a DSCR rate under 1 on a property you own, then it’s time to take action. You could refinance the property to reduce your principal and insurance payment. You could raise rental rates, if the market will allow. You might even need to do both to get your property back above water.

A DSCR of 1 means that money in equals money out on a monthly basis. Again, this is not ideal. You’re not generating any profit on an ongoing basis, and you have no margin to deal with major or even minor repair needs, unfilled rental units, or other unexpected surprises.

Your DSCR should be above 1 in order to ensure your investment has enough room if you need to pay for expenses outside of PITIA. These include:

  • Standard repairs (repainting, keys for new tenants, etc.
  • Capital expenses (replacing a worn-out roof or HVAC system, for example)
  • Property upgrades (such as flooring or countertop upgrades)
  • Vacancy (unrented units over one or more months)

These expenses aren’t included in PITIA, but you should plan for them. Establishing a DSCR of 1.2 or more allows you to budget for these kinds of expenses. Some investors may want to increase their DSCR ratio even higher.

Here’s a pro tip: If you have a property with more doors, or a portfolio of single-family rentals, you can profit with a lower DSCR. That’s because your volume of renters lessens the risk of a problem in one unit massively impacting the bottom line. You’ll be generating more overall profit, and therefore will have more cash on hand to cover rental vacancies, repairs, and other unpleasant surprises.

Two Investment Approaches, Two Maximums for DSCR

Is there a maximum DSCR for your investment? The answer is maybe, depending on your investment strategy.

A retiree who has a rental property or two to supplement their income will likely prefer a conservative approach. Therefore, the DSCR on that property may be quite high. That leaves plenty of profit, and plenty of cash on hand in case something goes wrong. This low-risk approach could push DSCR quite high—especially if the investor owns the property free and clear and only has to pay taxes, insurance, and association fees.

On the other hand, an investor looking to grow his portfolio will likely prefer a DSCR pretty close to 1.0 so they can use leverage to acquire more properties. This kind of investor may do a cash-out refinance on rental property to make his equity liquid. This will increase the property and insurance costs for a single property, but will provide more cash for the overall portfolio. In this case, a high DSCR equals equity that’s left on the table.

Conclusion

An investor needs to know how to calculate DSCR, and also needs to identify the right target DSCR for his or her strategy. Once you find the right target, DSCR becomes a powerful way to measure the success of your rental portfolio.

Dana Wasson is the Director of National Sales for Lima One Capital, the nation’s premier lender for real estate investors.