You may have seen the term “DCR” or “DSCR” while learning about flipping properties and had no idea what it meant. One of the downfalls of property investors is that we use far too many TLAs – three letter acronyms.
DCR stands for debt coverage ratio. DSCR stands for debt service coverage ratio and means the same thing. Understanding your debt coverage ratio is an important part of understanding whether your house flipping or buy and hold investment is actually a good deal. It will also be important for securing house flipping loans.
Your debt coverage ratio is used to measure your ability to pay a property’s monthly mortgage payments with income generated by the property. It’s a simple guide for assessing how much you can make on a property each year (or how much you’ll lose).
To calculate the debt coverage ratio, you need two numbers. First, you need to know the net operating income (NOI) of the property. This is the total amount of money that you can make off of the property every year by renting it out. Next, you need to know the annual debt service (this is where the S in DSCR comes from). The annual debt service is the total cost of your mortgage payments for one year including any accrued interest but excluding any escrow payments.
To get your debt coverage ratio, simply divide the net operating income by the annual debt service.
Here’s an example:
Say you’re renting out a small single family home, and you’re bringing in $38,000 annually in net income from the property, but your mortgage payments are $28,500 annually. When you divide 38,000 by 28,500, you get a debt coverage ratio of 1.33. That means that you are making 33% on the property every year.
Why does the DCR matter if you’re planning to flip a property? Because you always need a backup plan. If you’re unable to resell an investment property quickly, the best backup plan is usually to rent it out for a while in order to keep paying off your house flipping loans and avoid major losses. Most private lenders look for a debt coverage ratio of at least 1.25. The higher the ratio the better, generally speaking.
To get more helpful house flipping tips or to learn more about how to properly calculate your DCR, give our office a call at (559) 326-2509.