Debt Coverage Ratio explained

The debt coverage ratio(DCR) measures your ability to pay the property's monthly mortgage payments from the cash generated from renting the property.  Bankers and lenders use this ratio as a guide to help them understand whether the property will generate enough cash to pay rental expenses and whether you will have enough left over to pay them back on the money you borrowed. 

The DCR is calculated by dividing the property's annual net operating income (NOI) by a property's annual debt service. Annual debt service is annual total of your mortgage payments (i.e. the principal and accrued interest, but not your escrow payments).

EXAMPLE:

Assume NOI of $20,000 and debt payments of $15,000.  The DCR is 1.33,  ($20,000/$15,000 = 1.33).

A debt coverage ratio of less than 1 (e.g. .75) indicates that there is not enough cash flow to pay the property's rental expenses and have enough left over to pay mortgage payments. Obviously, a lender will not be willing to loan you money to purchase a property not generating enough cash to pay him/her back..  In the above example, the DCR of 1.33 means that the property will generate 1.33 times more (or 33% more) in cash that is required to pay the mortgage payments. 

This ratio is widely used by investors and hard money lenders.  I provide the DCR in my cash flow analysis for all my investor clients.