DSCR Loan Fundamentals: Understanding Requirements for Landlords and Real Estate Investors

Investing in rental properties has long been seen as a smart move, and this continues to be true with increasing tenant demand, high occupancy rates, growing rental income, and rising property values. The current hot rental market is driving serious real estate investors to expand their rental portfolios.

However, acquiring properties is just the first step. Securing flexible financing and a reliable lender is crucial for growing your business and closing great rental deals swiftly. In real estate, timing is critical, especially in a competitive seller’s market where quick approvals are essential. Many of the limitations of traditional funding are eased when using targeted, goal-focused debt-service coverage ratio (DSCR) loans , making them a favored option for eager investors. Let's delve into this non-traditional long-term financing option.

What is a DSCR Loan?

A DSCR loan , also known as a rental investment loan, rental loan or rental portfolio loan, is a type of hard money loan or private lender loan that is based on the property’s projected cash flow rather than the borrower’s income, unlike traditional mortgages. DSCR loans offer long-term financing for buy-and-hold or rental investment strategies. They require a down payment, a decent credit score, and charge annual interest similar to conventional mortgages.

How Does a DSCR Loan Work?

Unlike conventional mortgages that require extensive income verification, DSCR loans use the property’s cash flow during underwriting to determine eligibility. Borrowers don’t need to provide tax returns, pay stubs, or proof of income, making the process faster and easier. This streamlined process allows for quicker and simpler access to capital .

Qualification and Eligibility

To qualify for a DSCR loan , lenders consider factors such as the borrower’s credit score, down payment, and the property’s debt-service coverage ratio. The credit score typically affects the interest rate, while leverage is determined by both the credit score and DSCR. A higher DSCR means more leverage for the investor. Some lenders only perform a soft credit pull, which does not impact the borrower’s credit score.

What is the Debt Service Coverage Ratio (DSCR)?

DSCR is the ratio of operating income to debt obligations, used to measure a borrower’s ability to generate enough cash to cover their debt. It is a key metric lenders use to determine the maximum loan amount when an investor applies for a new loan or refinances an existing one. A higher DSCR indicates more net operating income available to service the debt. For example, a DSCR of 1.00x means the property generates $1.00 for every $1 owed.

How is DSCR Calculated?

To calculate DSCR, divide the net operating income (NOI) by the total debt service. Each lender may have a slightly different method for calculating these figures, so it’s important to confirm with your lender. Simply put, NOI is the property’s annual rental income minus operating expenses. This figure is then divided by the sum of principal, interest, taxes, insurance, and HOA fees, if applicable.

What is a Good DSCR?

Lenders typically consider a DSCR of 1.25 or higher to be good, as it indicates the property generates 25% more profit than expenses, ensuring positive cash flow as long as the property remains occupied. A DSCR below 1.0 means rental income is less than total debt service, which could lead to monthly losses.

Typical DSCR Loan Options

Many hard money lenders offer fixed-rate, adjustable-rate, or interest-only DSCR loan options, allowing investors to choose terms that best suit their property deals. Eligible property types for DSCR loans often include:

• Single-family rentals (SFRs)
• 2-4 unit rental properties
• 5 -8 unit Multifamily properties
• SFR Rental Portfolios with minimum of 2 properties
• Attached and detached planned urban developments (PUDs)

Ineligible properties typically include mobile homes, vacant land, log homes, and houseboats.

Pros and Cons of a DSCR Loan

Pros:

• Increased Accessibility: DSCR loans are accessible even if you don’t have a large amount of liquid capital since they don't consider personal income.
• Greater Investment Protection: Borrowing through an LLC or business entity can protect personal assets and other investments.
• Quicker Closings: Without the need for income verification, the application process is simpler and faster, enabling quick deal closures.
• Scale Faster: Unlike traditional mortgages that limit you to one property at a time, DSCR loans allow you to finance multiple properties simultaneously and offer cash-out refinancing options for further purchases.

Cons:

• Specific Loan Qualifications: Achieving high leverage and favorable rates depends heavily on having a good DSCR ratio.
• Higher Interest Rates and Down Payment: DSCR loans typically come with higher interest rates and require larger down payments compared to conventional mortgages.

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