Understanding DSCR—Debt Service Coverage Ratio—is key to leveraging your property’s earning potential and securing the right financing. In this post, our aim is to provide clear, practical insights for investors looking to navigate to the best debt in the short-term rental market.
A blatant plug!: Diggifi does DSCR loans, for STRs and other investor-owned housing! Get in touch with us here for a quick, free loan consult.
Understanding DSCR 🧐
DSCR, or Debt Service Coverage Ratio, is a financial metric crucial to the world of real estate investment. It measures a property’s ability to generate enough rental income to cover its mortgage and other related expenses. Simply put, it’s a ratio that compares your property’s income to its debts.
The Formula:
DSCR Loans: Tailored for Real Estate Investments
A DSCR loan is a type of mortgage specifically designed for investment properties. Unlike traditional loans, which focus on the borrower’s personal income and credit history, DSCR loans emphasize the property’s income-generating potential. This makes them ideal for investors in short-term rentals, where the property’s earning capability, rather than the borrower’s personal finance, is the key. STRs benefit even more – as the added benefit of STRs is that they can earn substantially more income than their Long-term Rental equivalents due to their (typically) higher nightly rates.
How Do DSCR Loans Work?
Assessing Property Income: Lenders evaluate the potential or actual rental income of the property.
Assessing Short-Term Rental Income: STRs have even more income-generating potential than their Long-term equivalents….if you’ve chosen the right property and market. These can help you get even more attractive financing terms, if you work with a lender that is willing to recognize the higher STR income potential. Once you’ve found that lender, then metrics like ADR, RevPar, and Occupancy rates matter a lot in making your case.
Calculating DSCR: The lender uses the DSCR formula, above, to determine if the property’s income is sufficient to cover the loan payments (which of course will vary with the size of the loan).
Loan Approval Based on DSCR: If the DSCR is above a certain threshold, the loan is likely to be approved.
The Magic Number for DSCR Thresholds: Minimum DSCR Ratio
The minimum DSCR ratio required for a loan varies by lender, but generally, a ratio of 1.0 or higher is preferred. A DSCR of 1.25 is even better – as it means that the property’s income is 125% of its debt obligations, providing a cushion for the lender in case of unexpected vacancies or expenses.
Refi’ing into a DSCR based on your strong STR rents
Did someone say “cheaper refi”? Now, your initial acquisition loan may have pencilled to a lower DSCR (and thus a less-attractive loan). However, once you’ve got operating history and proven STR incomes, you may be able to get a cheaper refi. How?
First, your proven income may exceed the income levels that were assumed for your initial acquisition loan. If so, jackpot! The higher income levels would juice your valuation and thus your loan proceeds, helping you get a cash-out refi done. This would free up some of the value in your valuable asset, allowing for reinvestment elsewhere. Second, even if you don’t look to draw down the excess loan proceeds, your higher DSCR may help you get a loan with better terms, as higher DSCR means less risk to your lender.
Practical Examples in the Short-Term Rental Market
Imagine a short-term rental property generating $50,000 annually, when you bought it. Further, assume yearly mortgage payments totaling $40,000. This property would have a DSCR of 1.25 ($50,000 ÷ $40,000), making it a viable candidate for a DSCR loan.
Then imagine that, due to your strong operating abilities, you managed to get revenues up to $60,000 annually – voila! Your DSCR is now 1.5 ($60,000 ÷ $40,000) and your valuation is likely higher, too. So you could convince your lender to make a larger loan (without negatively affecting LTV, due to your higher valuation) – thus freeing up your cash. Alternatively, you could a cheaper interest rate. Ideally, you could get both.
Final Thoughts: DSCR Loans as a Strategic Tool
DSCR loans offer a flexible financing solution for short-term rental investors, focusing on the property’s ability to generate income. Real estate investors can maximize their returns by understanding and utilizing DSCR effectively.
📞 Ready to Explore DSCR Loans for Your Investment?
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