Question:
“I’m a small-time real estate investor. I have a couple of rental condos in Mira Mesa and North Park, but I’d like to trade into an apartment building. I’ve been talking with people and asking a lot of questions. There’s a term I’ve heard called debt coverage ratio. What is that?”
Answer:
You’re getting into some moderately complex concepts, but I’m happy to explain…
When you buy a home to live in, the bank looks at YOUR ability to pay the mortgage.
When you buy a commercial investment property, the bank looks at the PROPERTY’s ability to pay the mortgage, based on rents and expenses.
The debt coverage ratio is the property’s net operating income or NOI (annual income minus expenses, not including mortgage) divided by the debt service (total annual mortgage payments):
NOI / Debt Service = debt coverage ratio.
A property with rents of $200,000 per year and expenses of $70,000 per year has an NOI of $130,000. If it has a debt service of $100,000, then:
$130,000/$100,000 = 1.3 debt coverage ratio
Last time I checked, banks were commonly looking for about a 1.3 debt coverage ratio, meaning they want your net rental income to exceed the loan payment by 30%.