When you apply for a property loan, the lender must assess (or underwrite) your ability to repay it in order to decide whether to grant the loan, how much to offer and what terms to require. Depending on the type of lender, the underwriting process might evaluate:
- The value of the property (before or after rehabilitation)
- The net operating income (NOI) of the property
- The borrower’s financial condition
- The borrower’s financial history
Debt service coverage ratio (DSCR) is a measure of the borrower’s financial condition. It indicates whether a borrower has sufficient cash flow to repay current debt, including interest. DSCR is defined as NOI divided by the total current debt service (i.e., the amount of debt obligations due within one year, including principal, interest, and lease payments).
DSCR = NOI / Total Debt Service
A DSCR of 1.0 means the borrower’s NOI is just enough to service debt. Values below 1.0 indicates insufficient cash flow, while values just above 1.0 are problematic, because a small dip in cash flow might require the borrower to use other funds to service debt. If those other funds aren’t forthcoming, the borrower might default on payments and force the property into foreclosure. Naturally, lenders want to avoid this eventuality, as it is expensive and time-consuming to seize and sell the property, often at a loss. Therefore, lenders might set a minimum DSCR as part of their underwriting requirements and require the borrower to maintain at least the minimum DSCR during the life of the loan.
Hard-money lenders are typically not that interested in DSCR. The money they lend is based on the post-rehab value of a fix-and-flip property. Usually the loan amount is around 80 percent of the property value, and the borrower finances the remainder with equity. This arrangement creates great incentive for borrowers to meet their debt service obligations lest they lose their investment. Furthermore, a fix-and-flip property has a negative NOI, so DSCR is difficult to calculate. Hard money lenders are more interested in the value of the property, as it serves as collateral for the loan.
Also bear in mind that, unlike mortgages, hard-money loans are non-amortizing. That is, debt service is interest only, and the principal is repaid all at once at the end of the loan. This translates into smaller payments and a smaller DSCR requirement. The proceeds from the flip of the property are used to repay the principal. That’s why hard-money loan underwriting concentrates on property value rather than the borrower’s finances. If you live in the Washington DC region, contact Specialty Lending Group for terms and rates on hard-money loans.