Many obstacles stand in the way of real estate investors getting the loans they need to scale their business — invasive and irrelevant income verification, too many tax writeoffs, slow underwriting, long waits for refinancing, high credit score requirements, limits on the number of loans you can have on any one time.
Is there a solution? DSCR loans offer an attractive viable alternative. These loans are designed for real estate investors and solve many of the problems that real estate entrepreneurs encounter in the search for financing — if you can handle the downsides. Yet many investors don’t even know these loans exist, or even the DSCR meaning.
Munoz Ghezlan Capital has acquired tens of millions of dollars in DSCR loan financing for real estate investors — many of whom had been told “no” by every mortgage broker in town — empowering them to achieve financial freedom well ahead of the schedule set by the bank. Let’s explore how DSCR loans fit into the strategy of thousands of real estate investors nationwide.
Key Takeaways
- A DSCR loan is a mortgage loan on investment property that uses the potential property income instead of the borrower’s personal employment for the income qualification process.
- Investors do not have to submit W-2s, pay stubs, personal tax returns, or proof of employment to get a DSCR loan.
- DSCR loans can fund quickly compared to conventional mortgages (5-15 days), fund into an LLC, and can be refinanced sooner than conventional mortgages.
- Because they are higher-risk for the lenders, DSCR loans carry somewhat higher down payment requirements, interest rates, and closing costs.
DSCR Meaning — Understanding the Debt Service Coverage Ratio
Debt service coverage ratio (DSCR) is a mathematical expression that calculates the relationship between two specific variables:
- The net operating income (NOI) of an income-generating property. This is all the annual income generated by the property (including rental income, fees, etc.) with all annual operating expenses (property taxes, insurance, utilities, repair expenses, management fees, etc.).
- The annual debt service. This is all the money the property owner must pay against any debt owed on the property, usually a residential mortgage, commercial mortgage, hard money loan, or other form of real estate debt. The debt service includes required principal repayment and interest payment.
Here’s the easy math equation that uses these two variables to arrive at the DSCR of the deal:
DSCR = NOI ÷ Annual Debt Service
If the property is in good financial health, the resulting number should be greater than 1. This means the property generates more net operating income than it needs to fully service the debt (i.e. make its loan payment obligations).
If, on the other hand, the DSCR equation results in a number that is less than 1, that’s a bad sign. It means the property does not generate enough net operating income to meet its debt service obligations.
Example of DSCR Calculation #1
Let’s say a property takes in $5 million in annual operating income and incurs $3 million in annual operating expenses. The owner owes monthly mortgage payments of $140,000.
Here’s how we would calculate the DSCR:
Operating Income - Operating Expenses = NOI
$5 million (operating income) - $3 million (operating expenses) = $2 million (NOI)
Monthly Debt Payment x 12 = Annual Debt Service
$140,000 x 12 = $1.68 million
Now that we have our terms (NOI and annual debt service) we can plug them into our equation:
NOI ÷ Annual Debt Service = DSCR
$2 million ÷ $1.68 million = 1.19
This property has a DSCR of 1.19. Not bad — the number is greater than 1, which is good news for the investor. Another way of understanding this number is that this property makes enough money to pay its mortgage with an extra 19% to spare.
Example of DSCR Calculation #2
Let’s look at one more example …
Suppose a property earns $20 million in annual operating income and has $14 million in annual expenses. The owner owes monthly mortgage payments of $540,000.
Let’s do the math again:
Operating Income - Operating Expenses = NOI
$20 million (operating income) - $14 million (operating expenses) = $6 million (NOI)
Monthly Debt Payment x 12 = Annual Debt Service
$540,000 x 12 = $6.48 million
Now the final DSCR calculation:
NOI ÷ Annual Debt Service = DSCR
$6 million ÷ $6.48 million = 0.93
Uh oh … this time we came up with a number less than 1. That’s bad news for the investor — a DSCR of 0.93 means that the property NOI is insufficient (by 7%) to cover the mortgage payment all year. To avoid default and possible foreclosure, the investor will have to cut expenses, increase income, or come up with sources of cash other than property operating income to cover the debt service.
What Is a DSCR Loan? DSCR Loan Explained
A DSCR loan is a type of primary real estate mortgage debt. However, unlike traditional mortgages, it primarily takes into account the cash flow of the property, rather than the income, tax returns, or employment history of the borrower.
In many ways a DSCR loan resembles a conventional mortgage. There’s a down payment, along with monthly principal and interest payments. The loan uses a deed of trust to create a lien on the property, securing the property as collateral for the loan.
The advantage of a DSCR morgtgage is the potential for fast funding, easier qualification, and flexible underwriting. The borrower does not need to submit W2s, personal tax returns, pay stubs, proof of employment, or debt-to-income calculations.
Instead, the lender will look at property income, market rents, and (of course) DSCR. The lender will also look at the borrower’s personal credit score, but the credit score requirements are often less stringent.
The downside of DSCR loans are higher interest rates, larger down payments, higher closing costs, and prepayment penalties.
What Types of Properties are Eligible for DSCR Loans?
The following types of properties typically qualify for a DSCR mortgage:
- Single-family homes
- Condominiums and townhomes
- Duplexes, triplexes, and fourplexes
- Some multifamily properties with 5 units or more
- Portfolio loans on portfolios of all of the above
How Much Can I Borrow?
There’s no hard-and-fast maximum balance for a DSCR loan, but here are some of the lending limits to watch out for:
- Standard: $1.5M-$3M
- Institutional/Higher End: $5M-$7.5M
- Portfolio: $5M-$10M+
- 5-8 Units: $3M-$10M
- Short-Term-Rentals: $2M-$5M
- Commercial: $10M-$50M+
Who Is The Lender?
DSCR loans are offered by non-QM lenders. “QM” stands for “qualified mortgage,” meaning it follows the strict underwriting guidelines of Fannie Mae, Freddie Mac, or CFPB. These Federal institutions set guidelines for mortgages that make them easy to sell on the secondary market, making them less risky for the lender.
A non-QM lender isn’t necessarily a subprime lender — they still underwrite their loans to verify that the lender will have the ability to repay their loan. It does mean they assume more risk, so the terms (LTV, interest rate, etc.) are likely to be less favorable.
When DSCR Loans Make Sense — Ideal Borrowers & Use Cases
Who are the ideal users for a DSCR loan? Such a loan makes the greatest sense for the following situations:
- Real estate investors who want to expand their portfolios.
- Airbnb investors who can demonstrate strong cash flow (or strong cash flow potential) in excess of the long-term market rent on the property.
- Real estate investors with many other mortgages or recent mortgages.
- BRRRR investors who want the ability to quickly refinance and move on to the next opportunity.
- Real estate investors with strong cash-flowing assets but inconsistent personal income.
- Entrepreneurs, self-employed persons, and gig-economy workers with strong income but no W2s or pay stubs.
- Investors who write off many expenses on their tax returns, making their income look lower.
- Out-of-state investors or turnkey-rental buyers.
DSCR Loan Requirements
Now that you know what a DSCR mortgage is and its potential uses, what does it take to qualify for one? Here’s what DSCR lenders look for:
- Minimum DSCR Requirement. Most DSCR lenders naturally want to see a DSCR of at least 1 — that way you have at least enough NOI potential to make your mortgage payment. Some lenders look for DSCR of 1.1, 1.2, 1.25, or more. With extenuating circumstances (a business plan to increase income or decrease expenses), a lender may consider a DSCR lower than 1. The higher the DSCR, the better the terms.
- Credit Score Requirements. DSCR lenders do check the credit of the borrower, though the minimum requirements are often lower, as little as 620, though some require 660 or 680. The best terms usually kick in at credit scores of 700 or higher.
- Down Payment & LTV. A DSCR mortgage usually requires a higher down payment and lower LTV — 20-25% down for acquisition, 25-50% down for refinance.
- Reserves Requirements. The lender will require you to verify that you have cash reserves in a bank account to cover several months’ worth of PITI (principal, interest, property taxes, and insurance). This could be anything from three months’ worth to twelve months’ worth, depending on the lender.
- Property Requirements. The property must be viable as an income-generating property, verified by an appraiser on Form 1007 of the appraisal (explained below).
- Entity Requirements. Many lenders prefer that the property be held in a limited liability entity like a corporation or LLC (which most real estate investors prefer anyway).
How DSCR Lenders Calculate Income
DSCR lenders have a number of tools at their disposal to calculate the rental income potential of a property.
For long-term rentals, lenders rely on Form 1007 of the appraisal. This is a section of the appraisal where the appraiser gives his/her professional opinion of the rental income potential. Just as the appraiser gives an opinion of the overall value of the property, the appraiser uses this form to give an official estimate of the market rent of the property — i.e. what rent the property would command on the open market.
If the property is already rented out with a lease agreement in place, the lender will take into account the “in-place” rent and adjust the appraiser’s estimate accordingly.
For short-term rentals, which can be seasonal and inconsistent in their income generation, lenders may use online data tools like AirDNA to calculate a property’s short-term-rental income potential. If the property is already being used as a short-term rental, the lender may ask for up to 12 months’ trailing rental history from whatever platform — Airbnb, VRBO, etc. — the owner is using.
The lender will estimate expenses as part of their underwriting — either based on trailing financial reports or comparable market rates — as well as a market vacancy rate. For short-term rentals, the underwriter will likely estimate a vacancy rate of 10-15%.
Step-by-Step: How to Get a DSCR Loan
Step 1: Identify the Property & Estimate Rental Income
Once you have selected the target property, you have several ways to estimate its income potential. If you already own and rent out the property, you have your lease in place and rental history. If the seller has rented out the property, you might be able to obtain the seller’s lease in place and rental history.
If you have no rental history available for the property, free online estimates like the Zillow Rent Zestimate or Rentometer can give you a rough estimate for long-term rentals; tools like Airdna can give you an estimate for short-term-rental potential. These aggregated data estimates are not perfect, though. Consider doing extra research, exploring Zillow or the MLS to see what similar, nearby properties have rented for recently. Check nearby and similar Airbnb and VRBO listings for short-term rental rates. If you own similar properties nearby, this will be a major source of insider data.
Ultimately, Form 1007 of the appraisal will be the final word, but do as much research as you can to make sure that the appraiser’s number doesn’t catch you by surprise.
Step 2: Gather Required Documents
You will need to submit your ID, entity formation and standing documentation (corporation, LLC, etc.), and any insurance documentation, lease agreements in place, and operating statements. You do not need to submit W2s, pay stubs, proof of employment, or personal tax returns.
Step 3: Apply with a Non-QM or DSCR Lender
Munoz Ghezlan Capital can give you access to a wide variety of non-QM lenders — one who caters to the exact use case you are looking for.
Step 4: Lender Orders the Appraisal
Make sure the appraiser has sufficient access to the property to complete the appraisal. Appraisal delays are a key reason that DSCR loans fail to fund quickly.
Step 5: Underwriting & DSCR Analysis
The underwriter crunches the numbers and determines whether the deal meets their requirements.
Step 6: Final Approval & Rate Lock
At the time of final approval, your interest rate will be locked based on the relevant interest rate index (usually the SOFR).
Step 7: Closing & Funding
The loan closes, and the proceeds go where they need to go according to the closing statement.
DSCR Loan Rates & Terms
- DSCR Loan Interest Rates. DSCR loans tend to run 1-3% higher APR than a conventional loan due to the higher risk to the non-QM lender. Variable interest rate periods may be available. Lower DSCR and LTV may qualify the borrower for lower interest rates.
- LTV. DSCR loans require higher down payments, meaning the loan-to-value (LTV) will run lower than conventional mortgages — usually 75-80% for acquisitions, 70-75% for refinance.
- Closing Costs. Closing costs tend to be higher on a DSCR mortgage, ranging from 3-6% of the loan balance (compared to 2-4% of the loan balance for a conventional mortgage).
- Term. Usually 30-year-fixed (same interest rate and fully amortized payment plan for 30 years). 40-year options may be available, as well as 5/6, 7/6, or 10/6 adjustable-rate mortgages (ARM).
Pros and Cons of a DSCR Loan Explained
Pros
- Fast Funding. Whereas standard loans can take months to be approved and funded, the standard for DSCR loans is 14-21 days. Rush jobs with paperwork in order can take as little as 10-14 days or even 5-7 days in rare circumstances.
- Fast Refinancing. Conventional lenders require your initial loan to be “seasoned” for 6-12 months before they will consider refinancing your loan. DSCR lenders, on the other hand, are much more amenable to fast refinancing, often requiring as little as 1-3 months. This is gold for BRRRR investors especially, as the next deal depends on refinancing the previous deal.
- No Limit on Number Of Loans. Conventionally lenders will eventually cut you off from getting more loans after you reach a certain number — kryptonite for investors eager to scale. DSCR lenders, by contrast, have no such limit and will continue to write loans as long as you keep bringing them viable deals to lend on.
- No Problem With Recent Loans. If you have taken out many recent loans, this will similarly hurt you with traditional loan underwriters. DSCR lenders, however, don’t care if you have taken out several loans recently — which is standard operating procedure for BRRRR and fix-and-flip investors.
- No Personal Proof of Income. Whereas conventional lenders ask for W2s, pay stubs, proof of employment history, and debt-to-income calculations, DSCR lenders require none of these. Instead, they require verification of rental income (or rental income potential). Not only does this mean less paperwork to collect, it’s significantly less invasive into your personal affairs.
- No Problem with Tax Writeoffs. One of the biggest headaches for investors is being told by conventional lenders that they “don’t make enough money” to qualify for a loan. (Their new Tesla and bank balances would testify otherwise.) This is because real estate investors qualify for significant tax deductions. This greatly reduces their tax burden … but puts a small number on their bottom-line tax return income, which conventional lenders have the nerve to hold against them. Because DSCR loans don’t even require tax returns for their underwriting, you can take every writeoff in the book and it won’t hurt your approval chances.
- Can Fund Into an LLC. Conventional lenders usually require that the loan proceeds fund into the personal account of the guarantor. This requires the investor to take title in his/her own name, a major liability concern. They can then transfer the property into the name of an LLC, but this risks triggering the “transfer-of-ownership” clause in a conventional mortgage. Investors end up holding the deed in the name of the LLC and the note in their own name, which is technically a no-no. DSCR lenders, on the other hand, have no problem funding the loan into an LLC, ensuring clean ownership with limited liability.
- No Tenants Necessary. While it can help to have a record of tenancy and rental income for the property, it’s not strictly necessary for a DSCR loan. Lenders will consider unoccupied properties based on the potential market rent. Because this is a bigger risk to them, the terms might not be as good, but you can still get your loan.
Cons
- Higher Interest Rates. Because DSCR loans are more risky to lenders than conventional loans that conform to Fannie Mae guidelines, they require higher interest rates, increasing the cost of borrowing.
- Higher Down Payments and Closing Costs. Similarly, due to the higher risk factor of DSCR loans, lenders will require higher down payments — 20%, 25%, even 30% — to reduce their risk.
- Strict Rental Income Requirements. Although you don’t need to make an invasive disclosure of your personal finances, you do need to make a decisive case for the rental income or income potential of the property. If the property is already generating income, detailed financial records (profit/loss statements, rent rolls, etc.) will be required. For unoccupied or unrented properties, a convincing pro-forma projection based on market rents must be presented.
- Prepayment Penalties. Whereas conventional mortgage lenders don’t care when you pay back the full principal balance, DSCR loans often include a prepayment penalty, which assesses extra fees if you pay off the loan earlier than 3-5 years. These fees can be high enough to erase a significant amount of your profit on the deal, especially for BRRRR and fix-and-flip investors, so be aware of them, make sure you understand them, and factor any proposed prepayment penalty into your profit projections before you agree to a loan.
- Potential for Delays. While known for their fast funding, missing paperwork and delays in appraisals can drag out the process to 30 days or longer. If time is of the essence, this can be a major liability.
- Must Pass Credit Check. While you don’t need to verify your personal income or employment to qualify for a DSCR loan, you do need to submit to a credit check. Score requirements are typically lower than those of conventional loans, but it is still a hurdle to watch out for.
Bottom Line
In a real estate lending ecosystem that seems to penalize real estate investors and slow them down at every turn, DSCR loans offer a significant lifeline. Their fast funding, fast refinance, cash flow-based underwriting, LLC-friendliness, tolerance for multiple loans, and disregard of the personal finances of the borrower make them an ideal vehicle for real estate investors who want to expand their portfolios quickly.
This comes at the cost of higher down payments, interest rates, closing costs, and cash reserve requirements. However, for real estate investors of a certain level or professional background, these loans can make deals possible that previously seemed impossible.
Munoz Ghezlan Capital works every day to secure for these real estate investors the crucial financing they need to grow, prosper, and achieve their financial dreams. If you are a current or aspiring real estate investor who has heard “no” too many times from the run-of-the-mill mortgage broker, Munoz Ghezlan Capital can help.
Reach out to us today for a complimentary strategy session to find out whether a DSCR loan could be the key that unlocks your empire.
