Every industry has its metrics and its jargon, and real estate investing is no different. Experienced investors will drop abbreviations like “LTV” and “DSCR” for many reasons. To save the breath it takes to speak long phrases like “debt service coverage ratio.” To show off. To gatekeep — find out if the person they’re speaking to is “in the club.”
Mastery in any industry involves learning the terminology — not just how to drop them in conversations at cocktail parties, but what they mean and how they relate to your success in the industry.
For real estate investors, LTV and DSCR are particularly important real estate loan metrics to understand because they will come up in the process of applying for a mortgage loan, the instrument of debt leverage that almost singlehandedly gives real estate investing the potential for scalability and wealth-building.
Specifically, LTV and DSCR relate to how much money a mortgage lender will lend you for a particular deal. Munoz Ghezlan Capital has helped hundreds of real estate investors not only understand these terms, but use them to acquire the debt they need to scale. Let’s take the time to fully understand loan to value vs DSCR … and how lenders use them to decide how much to lend you.
Key Takeaways
- Loan-To-Value (LTV) is the percentage of the property’s value — as determined by a professional appraiser — that the lender will finance. How much LTV a lender will approve depends on the intended use of the property and the buyer’s creditworthiness. The remaining purchase price not covered by the loan becomes the buyer’s down payment.
- Debt Service Coverage Ratio (DSCR) applies only to investment properties intended for long-term or short-term rental. It calculates whether the property is capable of generating enough rental and fee income to cover the mortgage payment. Investment property lenders will typically require a minimum debt service coverage ratio.
- LTV and DSCR work together to help lenders decide how much money they are willing to lend on a specific investment property acquisition or refinance.
LTV Ratio Explained
“LTV” is an abbreviation for “loan-to-value.” It represents the percentage of the value of the property that the lender is willing to let the buyer borrow with that property as collateral for the debt.
Let’s do a quick example. Suppose a buyer approaches a lender requesting a mortgage on a property that is worth $1,000,000. The lender determines that the property use case and the buyer’s creditworthiness justify 80% LTV. That means that the lender would be willing to lend up to $800,000 for the purchase of the property. The remaining $200,000 must be furnished by the buyer as the down payment.
If the same buyer were to present the lender with a similar property valued at $500,000, the lender would be willing to lend up to $400,000, with the remaining $100,000 as the buyer’s down payment.
We see therefore an inverse relationship between LTV and the buyer’s down payment — as one goes up, the other goes down. If the lender approves an 80% LTV, the buyer’s down payment is 20%. If the LTV is 90%, the down payment is 10%.
NOTE: A buyer can always request less LTV than the lender approves, but not more. For example, a lender might offer 80%, but a risk-averse buyer might request a 70% LTV loan to avoid overleveraging. However, that same buyer can not press for a 90% LTV, because in this scenario 80% is the lender’s maximum tolerance for LTV.
What LTV do Lenders Usually Approve?
What LTV can buyers expect from mortgage lenders, based on the use case of the property and the creditworthiness of the borrower?
LTV is different from DSCR in that it applies to owner-occupied primary residences as well as investment properties, whereas DSCR only applies to rental investment properties.
How much LTV a lender will approve depends on how risky they perceive the acquisition to be. Will the borrower work hard and make sacrifices to pay the mortgage if the borrower falls on hard times or the property underperforms? Or will the borrower decide it’s easier to just walk away and let the lender foreclose, leaving the lender with a potentially distressed property?
As such, when the deal is considered more risky, lenders will require the borrower to have more “skin in the game” (down payment money out of their pocket) and lend a lower percentage of the property’s value in hopes that, worst case scenario, they will be able to sell the foreclosed property for more than the remaining debt balance.
Lender LTV tolerances change over time as markets shift, but here are some benchmarks that have broadly applied:
Owner-Occupied Primary Residence
Owner-occupied primary residences are considered lower-risk to lenders because the owner will go to great lengths to avoid losing the home they live in, likely with their family. As such, lenders are comfortable with higher LTVs on owner-occupied primary residences.
Conventional Loans that Conform to Fannie Mae and Freddie Mac Guidelines:
- Standard — 90% LTV (10% down)
- First-time buyers — up to 97% LTV (3% down)
- Repeat buyers — 95% LTV (5% down)
FHA Loans
- 96.5% LTV (3.5% down)
VA Loans
- 100% LTV (0% down)
Jumbo (Non-Conforming) Loans
- 90-97% LTV (3-10% down)
Second Home or Vacation Home
Second homes and vacation homes are considered riskier by lenders, since a second home is more likely to be sacrificed to default than the primary residence if the borrower encounters financial difficulty. Still, they are seen as less risky than most investment properties.
Conventional Loans that Conform to Fannie Mae and Freddie Mac Guidelines:
- 90% LTV (10% down)
Jumbo (Non-Conforming) Loans
- 70-80% LTV (20-30% down)
Investment Properties
Lenders consider investment properties to be riskier than owner-occupied properties, with the borrower more likely to walk away if the deal underperforms.
Single-Family Loans that Conform to Fannie Mae and Freddie Mac Guidelines:
- 75-80% LTV (20-25% down)
2-4 Unit Loans that Conform to Fannie Mae and Freddie Mac Guidelines:
- 70-75% LTV (25-30% down)
DSCR-Based Non-Conforming Loans
- 80% LTV (20% down) for acquisitions
- 75% LTV for cash-out refinance
- 70% LTV (30% down) if DSCR is less than 1
- 65-75% LTV (25-35% down) for Airbnb or short-term rental use
Mixed-Use Properties
- 70-80% LTV (20-30% down) for acquisitions
- 65-75% LTV for cash-out refinance
What Determines the Value of the Property?
If LTV depends on the value of the property (it’s the “V” in the abbreviation), how does the lender determine that value?
It’s not the listing price or even the agreed-upon purchase price. The final determination of the value of the property comes from the appraiser, a neutral professional hired to give an informed opinion of value based on current market and property conditions.
This is why brokers, buyers, and sellers work hard to agree on a purchase price that does not exceed the appraised value — because the appraisal is what lenders use in their LTV calculations.
Suppose a buyer and seller agree to a purchase price of $500,000. The buyer expects to borrow 80% LTV, or $400,000, and put $100,000 down. But there’s a problem — the appraiser concludes that the property is only worth $450,000. The lender will only be willing to lend 80% of the appraised value — $450,000. 80% of $450,000 is only $360,000, and that’s the most the lender will agree to lend.
Uh oh … the buyer and the seller have a deal for $500,000. The buyer must now come up with $40,000 in extra down payment, attend to renegotiate the price down, or watch the deal slip away.
Note To Fix-and-Flippers — LTC instead of LTV
For fix-and-flip investors seeking a hard money loan or bridge loan, a related but different metric comes into play — LTC or loan-to-cost. Instead of the value of the property, lenders look at the total project cost — the purchase price, plus the expected rahab cost.
Hard money and bridge lenders will usually lend 70-80% LTC to brand-new flippers and 80-85% LTC to experienced flippers. This means they are lending a portion of the rehab budget.
However, they will cap their lending tolerance based on the ARV (after-repair value) — the amount they expect the investor to be able to sell the property for after a successful rehab. They will require an appraisal of the ARV, and they usually will not lend more than 65-75% of the appraised ARV, even 70-80% LTC is higher.
DSCR Meaning in Real Estate
Unlike LTV, DSCR only applies to investment properties that the borrower intends to use as a long-term or short-term rental.
DSCR is an abbreviation for debt service coverage ratio. It’s a metric for how effective the property will be at generating enough income to cover the mortgage payment and associated costs.
DSCR is determined by an equation that is simple at its core. It looks like this:
DSCR = NOI ÷ Annual Debt Service
“NOI” refers to “net operating income.” We find it by taking the annual operating income (rent, fees, etc.) and subtracting the annual operating expenses (utilities, repairs, insurance, property taxes, management, etc.)
“Annual debt service” refers to a whole year’s worth of mortgage payments.
When you do the math, you will arrive at a number that could be greater than 1, equal to 1, or less than 1.
A DSCR greater than 1 means the NOI is sufficient to cover the debt service with room to spare — extra cash flow that the owner can pocket as profit.
A DSCR equal to 1 means the NOI is just barely sufficient to cover the debt service, with no cash flow profit left for the investor.
A DSCR less than 1 means the NOI is insufficient to cover the mortgage payment, meaning the investor will have to come up with extra cash from a source other than property income to cover the mortgage.
Examples of DSCR Calculation
Let’s do a few sample calculations to better understand the DSCR meaning in real estate.
Suppose an investor brings a deal to a mortgage lender asking for a $5,000/month mortgage payment. That’s an annual debt service of $60,000. The lender analyzes the deal and determines that the property is capable of $68,000 NOI.
NOI ÷ Annual Debt Service = DSCR
$68,000 ÷ $60,000 = 1.13
We have a DSCR greater than 1, which is good news. Specifically, that number — 1.13 — means the investor can reasonably expect to cover the entire mortgage payment with 13% extra to keep as profit cash flow.
Let’s suppose, however, that the lender determines the NOI potential of the property to be $58,000 instead of $68,000. The math looks like this now:
$58,000 ÷ $60,000 = 0.96
Now we have a DSCR that is less than 1. This number means the expected NOI will be 4% too low to cover the mortgage payment the investor is requesting.
How Is NOI Calculated?
Lenders use a variety of resources to estimate the potential NOI when they calculate DSCR. These include:
- In-Place Leases and Rent. If the property is already being used as a rental, the lender can use financial statements for the current operation as real-world evidence of its income potential.
- Form 1007 on the Appraisal. This is a form within the appraisal where the appraiser gives an opinion of the property’s market rent. Usually well-calibrated for long-term rental potential, but not at all reflective of the property’s potential as a short-term rental or Airbnb.
- Data Aggregators. Companies like AirDNA collect data that can be used to estimate a property’s income potential as a short-term rental or AirBNB.
- Expense and Vacancy Benchmarks. Remember, NOI isn’t just the property’s income potential — it’s income minus expenses. Lenders will apply benchmark assumptions for expenses to the calculation — for example, 5-10% of the total operating income for vacancy loss, 10-40% of the total operating income for operating expenses, etc.
Minimum DSCR for Investment Property Loans
When lenders consider DSCR-based investment property loans, they usually have a target DSCR in mind. As you can imagine, the ideal minimum DSCR is at least 1 — that gives the lender reasonable confidence that the investor can at least collect enough rent to cover the mortgage payment.
Some lenders require higher DSCRs — 1.1, 1.2, 1.25, etc. Some lenders will consider a DSCR under 1, but this will affect their LTV tolerance (explained below).
Loan to Value vs DSCR – How They Work Together to Determine the Loan Balance
For DSCR-based loans, LTV and DSCR work hand-in-hand. The deal must satisfy both the lender’s required tolerances for these real estate loan metrics.
Let’s do another example to illustrate this point. Suppose an investor brings a DSCR lender a deal for an investment fourplex with a purchase price of $800,000. The lender is willing to lend 80% LTV, so the investor is hoping for a $600,000 loan.
But the lender also wants the deal to have a DSCR of at least 1.15. We now need to know the expected NOI and debt service for the deal.
Based on prevailing interest rates, that $600,000 loan will carry a monthly mortgage payment of $4,000 — or $48,000 in annual debt service.
The appraisal comes back with a value estimate for the property of $840,000. Good news! It actually appraised over the agreed-upon purchase price. But hold on — turning to Form 1007 of the appraisal, the lender sees an estimated market rent of $1,800 per unit. It’s a fourplex, so multiply by 4 and you get $7,200 in rent potential per month. Multiply by 12 months, and you get annual operating income potential of $86,400.
The lender deducts 40% from this number to account for expenses and vacancy. The expected NOI is now $51,840.
We have our annual debt service. We have our expected NOI. Let’s do the math:
$51,840 ÷ $48,000 = 1.08
Houston, we have a problem. The property’s appraised value is more than high enough, but the DSCR is below the 1.15 that the lender wants to see.
What is the lender to do? One option would be to loan the investor less money — below the 80% they were willing to lend on the purchase price and the even higher appraised value — to bring that DSCR to 1.15.
For example, the DSCR on the deal would be 1.15 if the annual debt service was $45,000 per year instead of $48,000. That’s a mortgage payment of about $3,750 per month. Based on the same interest rate assumptions, that leaves us with a loan balance just over $560,000 that would meet both the lender’s LTV and DSCR limits — $40,000 less than the investor had hoped for.
Bottom Line
This has been a lot of math, but the key takeaway is that both LTV (loan to value) and DSCR (debt service coverage ratio) play key roles in determining what loan balance a mortgage lender.
- LTV represents the maximum percentage of the value of the property a lender will loan, based on the appraised value and the creditworthiness/experience of the borrower.
- DSCR represents the ability of the property to generate enough net operating income (NOI) to cover the mortgage payment the buyer is asking for.
If one or the other metric does not pan out — appraisal too low, DSCR too low, etc. — a DSCR lender is likely to either reject the application or adjust down the balance they are willing to lend so that both real estate loan metrics fall within their tolerance.
For this and many other reasons, getting approved for an investment property loan can be a tricky needle to thread … but Munoz Ghezlan Capital is here to help you thread it. We’ve helped hundreds of investors crunch the numbers and then matched them to the lender who will approve them for the full balance of the loan — often in record time.
If you’re not sure if your deal adds up, schedule a free strategy call with us today so we can help you get every dollar you deserve.
