Colin was a smart guy. He was entrepreneurial and owned a property management firm, and now he wanted to grow his real estate investments. He was upwardly mobile, having changed jobs several times over the last few years and then starting his own company. Because of a lack of long-term W-2 income, Colin could not get traditional mortgages under the terms of Fannie Mae/Freddie Mac OR from bank portfolio loans.
But America was built by people like Colin, who have the determination to make good things happen, regardless of the establishment telling him NO.
Colin found a DSCR lender and was able to close on a small apartment building without giving over his first-born puppies and left arm, as is typical with a traditional lender.
What is a DSCR loan?
A DSCR (Debt Service Coverage Ratio) loan is a type of real estate loan where the approval and terms are primarily based on the property’s ability to generate enough income to cover its debt obligations.
This loan product is designed with income-generating properties in mind, such as residential or small multifamily housing. Unlike traditional loans, which often focus on the borrower’s creditworthiness, DSCR loans prioritize the financial performance of the property itself. This makes them particularly useful for investors whose personal financial profiles may not align with conventional lending standards.
When investors speak of a “DSCR loan”, most of the time they are referencing a loan that is focused on smaller multifamily investments or Airbnb-type income-generating properties and is based on the cash flow of the asset.
DSCR loans cannot be used for primary residence or commercial properties. They are typically used for 1-10 unit residential properties – short-, mid-, or long-term rentals.
It is important to note that commercial/industrial investments DO use a DSCR metric to determine the viability of the loan. However, a bank loan calculates the debt service coverage ratio differently from a DSCR loan.
- The DSCR from a bank is based on the net operating income divided by the debt service (principal and interest).
- However, with a DSCR loan, that ratio is calculated without all property expenses: the DSCR ratio is calculated by dividing the gross rental income from the property by the PITIA (principal + interest + taxes + property insurance + association dues, if applicable).
Essentially, this means that some of the expenses of a property that a bank would consider – like vacancy, maintenance, management, and utilities – are NOT calculated in a DSCR loan, potentially allowing for greater loan value.
When are DSCR loans a good fit?
1. Properties with Strong Cash Flow
One of the most important factors for a DSCR loan is the property’s cash flow. These loans are well-suited for investors who are purchasing or refinancing properties with reliable and strong income streams. Properties such as apartment complexes, rental homes, and Airbnb rentals can provide a steady income stream to support the loan. If you’re opening a new rental, the estimated income of the targeted use can be to support the loan and appraisal.
For example, an investor who owns a multifamily property with stable occupancy rates and reliable rental income may find that a DSCR loan is a perfect fit for their refinancing. The property’s income will be used to demonstrate to the lender that it’s able to service the loan’s debt, which is the primary concern in the underwriting process.
2. Investors with Limited Personal Credit or Financial Documentation
For investors who may not have stellar personal credit or complete financial documentation, DSCR loans can offer a viable solution. Since these loans are underwritten based on the property’s cash flow rather than the borrower’s personal financial situation, they provide a financing option for those who may not personally qualify for traditional loans.
Real estate investors who operate as self-employed individuals, or hold multiple properties, might not have the income history or debt ratios that traditional lenders want to see. DSCR loans remove that obstacle by focusing on the profitability of the investment property, rather than the borrower’s personal finances. This is ideal for experienced real estate investors who are reinvesting in new properties but may not have the traditional documentation to back their mortgages.
Investors looking to partner together in an LLC may also find these loans are a good fit, as investing in an LLC will eliminate traditional residential loans but can offer more flexible terms than a bank’s commercial mortgages.
3. Investors Looking for Flexible Financing Terms
DSCR loans often come with more flexible terms compared to traditional loans. Many DSCR lenders offer interest-only payments for a specified period, allowing investors to keep their cash flow high during the initial years of ownership. This flexibility can be beneficial for investors who want to focus on property improvements or expansions before tackling their larger debt payments.
Additionally, DSCR loans may offer a variety of loan term lengths, amortization schedules, and loan structures, allowing the investor to choose a repayment plan that aligns more closely with their long-term investment goals.
Unlike bank loans that rarely go longer than 25-year amortization, DSCR loans are usually fixed for 30 years, making them a more permanent solution. They may also offer adjustable-rate loans which float to the market after a certain time.
4. Investors Refinancing Existing Properties
Refinancing can be a smart strategy for investors looking to improve cash flow or free up capital for additional investments. DSCR loans are an excellent fit for refinancing income-generating properties because they assess the current income to determine loan eligibility. Investors with properties that have appreciated or increased their cash flow since acquisition can benefit from refinancing with a DSCR loan.
Investors looking to use the BRRR strategy to grow their portfolio may also find DSCR loans to be a great fit, as the cash out is based on the rental income from the newly placed, higher rents.
When might DSCR loans not be ideal?
While DSCR loans offer many advantages, they are not a fit for every situation. Properties that do not generate enough income to meet the lender’s minimum requirement will struggle to qualify for this type of loan. Additionally, if the property is underperforming or in a market with high vacancy rates, it may not generate enough income to secure favorable terms, even if it does qualify for the DSCR loan.
Furthermore, some DSCR loans may come with higher interest rates (typically at least 100-200 basis points higher than traditional sources) or fees compared to traditional loans, reflecting the added risk to the lender.
DSCR loans may also have pre-payment penalties built in, of varying lengths and terms. Watch your terms carefully. Investors should carefully weigh the costs of a DSCR loan against other financing options to ensure it aligns with their investment strategy.
Conclusion
DSCR loans can be an excellent fit for real estate investors who are focused on income-generating properties. Whether used for new acquisitions or refinancing, these loans prioritize the property’s cash flow, providing more flexibility for investors who may not meet the traditional lending criteria.
We connect investors with flexible options that are right for their goals and plans.
Call our team to discuss and refine your strategy for growth.
Sources
https://crosscountrymortgage.com/resource-center/what-is-dscr-loan
