Your lender will use a debt coverage ratio (DCR) to help figure out whether a multiunit investment property will yield enough net operating income (NOI) to cover the debt service and still leave some margin of safety.4 Lenders want to satisfy themselves that even if rent collections fall or property expenses increase, you will still be able to make your mortgage payments without dipping into your personal funds.
You can calculate the debt coverage ratio according to this formula:
Debt coverage income (DCR) =
Net operating income (NOI) Annual debt service
An illustration: Let's return to that eight-unit property. Plugging in the relevant numbers, we calculate the debt coverage ratio as
4. To investors, the term "debt service" means the same thing as mortgage payments.
Most mortgage lenders like to see a debt coverage ratio of at least 1.1, and preferably in the range of 1.15 to 1.3. The higher this ratio, the better. The more net income you collect relative to the amount of your mortgage payments, the larger your margin of safety.
Even though you're a beginning investor, I would encourage you to see what types of small income properties are available in your area.5You will find that these properties (typically 5 to 24 units) will usually give you more cash flow and higher debt coverage ratios than single-family rental houses. As a result, you may be able to finance a larger loan on a more costly property. That has certainly been my experience.
5. You might also profit by reading my book, Make Money with Small Income Properties (New York: John Wiley & Sons, 2003).
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