What is Debt Service Coverage Ratio (DSCR)?
When deciding whether to issue FHA multifamily construction loans to borrowers, one of the most important aspects a lender looks at is DSCR, or Debt Service Coverage Ratio. DSCR is a measurement of annual cash flow vs. annual debt obligations.
DSCR's Role in Multifamily Loans
The formula for calculating DSCR for HUD multifamily loans (and other multifamily and commercial loans) looks like this:
DSCR = Net Operating Income / Annual Debt Service
For example let's look at a multifamily property with an annual net operating income of $2,000,000 and annual debt of $1,500,000:
$2,000,000/$1,500,000= 1.33 DSCR
Considering the fact that most lenders prefer a DSCR of 1.20 or above, the example property would be well within the range of acceptability. The higher a property's DSCR, the lower the chance that the borrower will default on the loan due to unexpected expenses or other financial issues.
Keep in mind that a 1.0 DSCR is simply breaking even. So, it makes sense that FHA multifamily construction loan lenders would want some cushion between a property's annual income and debt obligations. However, the lower the DSCR requirement of the lender, the more money a developer can borrow (assuming the building's income and debt obligations stay the same.)
DSCR AND Loan-to-Value Ratio (LTV)
One thing that may allow a developer to get a multifamily loan with a lower DSCR is if the building's loan-to-value ratio (LTV) is lower.
LTV = Loan Amount / Total Value
In practice, that usually means that the developer either puts more cash into the project, or finds a deal in which they can purchase a multifamily property for less than the property's appraised value, therefore lowering the LTV of their potential loan. In turn, that can allow them to get away with a lower DSCR.