DSCR Loans: How to Meet the Requirements for Business Loans

What is a DSCR Loan?

A DSCR loans (Debt Service Coverage Ratio) loan, also known as a ‘non-recourse loan’, is a type of commercial real estate loan that only considers the property’s projected net operating income to determine repayment ability, without looking at the borrower’s income, credit score or financials.

With a DSCR loans, the lender evaluates if the property’s net operating income (NOI) is sufficient to cover the proposed mortgage payment, typically requiring a minimum DSCR of 1.20 or higher. This means the NOI needs to be at least 20% higher than the annual debt obligation.

How DSCR Loans Work

  • The lender analyzes the property’s NOI based on its rents, vacancy rates, operating expenses and capital expenditures. NOI equals rental income minus expenses.

  • They divide NOI by the proposed annual mortgage payment to see if it meets the minimum DSCR requirement.

  • As long as the DSCR ratio is satisfactory, the lender may approve the loan, regardless of the borrower’s credentials.

Pros of DSCR Loans

  • Qualification is easier for borrowers since personal income/credit are not factors.

  • Larger loan amounts are possible compared to conventional loans.

  • Interest rates may be lower than other commercial loan options.

  • There is more flexibility in use of funds since the property’s performance is the main consideration.

Cons of DSCR Loans

  • A larger down payment is usually required, often 30-35% of property value.

  • DSCR requirements mean the property must have sufficient net income.

  • Interest rates may fluctuate over the loan term.

  • Prepayment penalties and higher origination fees are common.

  • Lenders will only finance up to a certain percentage of appraised value.

So in summary, a DSCR loan bases approval primarily on the property’s projected cash flow alone, making qualification easier for borrowers. The tradeoffs are larger down payments, stricter property performance requirements, and potentially higher costs.

DSCR Loans Eligibility

To qualify for a DSCR loan, borrowers must meet certain requirements related to their credit score, income, and the property they wish to purchase.

Credit Score

  • Minimum credit score of 620 required. Some lenders may require higher scores of 640 or 660.
  • Lower credit scores may be acceptable with a larger down payment or higher DSCR.
  • Lenders will review your credit history, looking for on-time payments, low debt-to-income ratio, and no recent bankruptcies or foreclosures.

Income

  • DSCR loans do not have strict income requirements. Your income is not as important as the property’s potential rental income.
  • However, you still need verifiable income to show you can make the down payment and cover the mortgage if units are vacant.
  • Self-employed borrowers will need to provide tax returns and bank statements to confirm income.

Property Requirements

  • The property must be a 1-4 unit, non-owner occupied investment property.
  • Commercial properties, primary residences, and vacation homes do not qualify.
  • The property should ideally have a strong rental history with minimal vacancies to support the DSCR.
  • An appraisal is required to confirm the property’s value and determine maximum loan amount.

Required DSCR loans Ratio

The debt-service-coverage ratio (DSCR) is one of the most important requirements for qualifying for a DSCR loan. The DSCR represents the property’s net operating income divided by its total debt service payments.

Lenders want to see that the property generates enough income to sufficiently cover the proposed loan’s monthly principal and interest payments. A higher DSCR indicates the property can more easily handle the new loan payment.

Typical DSCR ratios required by lenders range from 1.20 to 1.50. For example, if the net operating income is $100,000 per year and the proposed annual debt service is $60,000, the DSCR would be 1.67 ($100,000/$60,000). This would meet most lenders’ requirements.

Some lenders may allow a lower minimum DSCR of 1.0 for strong borrowers. On the other hand, a DSCR above 2.0 may be required for riskier properties or borrowers. The required DSCR can also vary based on factors like the loan-to-value ratio.

In summary, the debt coverage ratio compares the property’s net operating income to the new loan’s total monthly payments to ensure the property can support taking on additional debt. Meeting the lender’s DSCR requirement is essential for qualifying for a DSCR mortgage.

Documentation required

To qualify for a DSCR loan, borrowers must provide extensive documentation to demonstrate that the property will generate sufficient income to cover the proposed mortgage payment. Lenders will carefully review these documents before approving a DSCR loan.

Tax returns

Lenders will require 2 years of personal and business tax returns to verify the borrower’s income and expenses. Tax returns must be complete copies including all schedules and attachments. Lenders analyze tax returns to determine the net operating income of the property and ensure it meets the minimum DSCR threshold.

Bank statements

Personal and business bank statements for the past 2 years are required. Statements should show regular deposits of income that align with the amounts on tax returns. Large deposits will need to be documented with a paper trail showing the source of funds. Bank statements help lenders confirm the consistency of income and expenses.

Rental agreements

For investment properties, copies of current rental or lease agreements must be provided. This allows lenders to calculate potential rental income and determine if it satisfies debt service coverage requirements. Agreements should be bona fide arms-length contracts reflecting market rental rates.

Profit and loss statement

A current year-to-date profit and loss statement will be required to evaluate ongoing financial performance. The P&L provides greater insight compared to tax returns alone. Lenders want evidence that properties are being well-managed and maintaining healthy cash flow.

Other documents

Additional documentation could include business licenses, franchise agreements, commercial leases, occupancy permits, insurance policies, and bills for operating expenses. Thorough documentation gives lenders confidence in the property’s income producing potential. Borrowers should be prepared to provide any papers needed to support income claims.

Down Payment Amount

The typical down payment requirement for a DSCR loan is 20-25% of the property’s value. Some lenders may accept a lower down payment of 15-20%, but the interest rates are usually higher. The larger the down payment, the more likely the lender is to approve the loan.

A 25% down payment on a $500,000 property would be $125,000. A 20% down payment on the same property would be $100,000. The down payment demonstrates the borrower’s commitment to the investment and ability to cover costs if the property’s income doesn’t cover the full mortgage payment.

Most lenders require the down payment to come from the borrower’s own funds rather than being gifted or borrowed. Proof of funds availability will be required via bank statements and documentation showing the source of the down payment amount.

Overall, investors should be prepared to make a sizable down payment for a DSCR loan, often 20% or more of the total property value. The exact percentage required depends on the specific lender’s criteria, the property type, and the borrower’s existing real estate portfolio.

Interest rates DSCR loans

Current interest rates on DSCR loans range from about 7-9%, although they can sometimes go higher depending on the lender and market conditions. Interest rates are typically variable rather than fixed.

Several key factors impact the interest rates lenders will offer on DSCR loans:

  • The property location – Interest rates tend to be higher for properties located in more competitive real estate markets. Lenders view these as riskier investments so they charge higher rates.

  • Loan-to-value ratio – The higher the LTV ratio, the higher the interest rate will likely be since the lender is taking on more risk. LTV ratios on DSCR loans often fall between 60-80%.

  • Credit score/history – While DSCR loans don’t require good personal credit, lenders still look at credit profiles. Better credit means better chances for lower rates.

  • Debt service coverage ratio – The DSCR measures the property’s net operating income against its debt obligations. The higher the ratio, the lower the interest rate since it indicates you can more easily repay the loan.

  • Loan term – Shorter loan terms often mean lower interest rates. Lenders consider longer terms riskier.

  • Additional collateral – Providing additional collateral like other real estate or investments can sometimes help borrowers get lower rates from lenders.

  • Market competition – When there are more lenders competing for deals, it can drive interest rates down across the board.

Understanding these key factors provides insights into interest rate variability for DSCR loans. It’s important for borrowers to shop around and negotiate the lowest rate possible for their specific situation.

Loan Term Lengths

Typical loan terms for DSCR loans range from 5 to 30 years. Shorter term loans like 5 or 10 years may have lower interest rates, but require higher monthly payments. Longer term loans of 20-30 years have lower monthly payments, but the overall interest paid is higher.

Most lenders offer terms in increments of 5 years, such as 5, 10, 15, 20, 25 or 30 years. 7 and 12 year terms may also be available. The term length largely depends on the specific lender’s offerings.

Investors usually choose a loan term length based on the anticipated holding period of the investment property. For properties expected to be sold sooner, shorter terms are preferred. For long-term buy and hold strategies, longer 20-30 year loans make sense to keep payments low.

If the loan will be paid by rents from tenants, then longer terms can match the length of the leases and reduce the risk of rents being insufficient to cover the required payment. However short terms provide faster equity build up in the property.

Overall the loan term length will impact the affordability of monthly payments and the total interest paid over the life of the loan. Investors should carefully consider their investment timeline when choosing a DSCR loan’s term.

Prepayment Penalties

When taking out a DSCR loan, borrowers need to be aware of potential prepayment penalties that may be incurred if the loan is paid off early. Lenders often impose these penalties to ensure they receive an acceptable return on investment for the loan.

Common Prepayment Penalty Structures

There are a few common prepayment penalty structures that borrowers may encounter with a DSCR loan:

  • Declining penalty – This is the most borrower-friendly option. The prepayment penalty starts high (often around 5% of the outstanding loan balance) and declines each year over the course of the loan. For example, a 5-4-3-2-1 structure would charge 5% in year 1, 4% in year 2, 3% in year 3, and so on. After year 5 there is no longer a prepayment penalty.

  • Fixed penalty – With this structure, the prepayment penalty remains the same (often 3-5% of the outstanding balance) throughout the entire term of the loan. This offers the least flexibility for borrowers looking to refinance or pay off the loan early.

  • Lockout period – Some lenders prohibit prepayment entirely for the first few years of the loan (known as the lockout period). This ensures the lender receives interest payments for a set minimum period of time. Common lockout periods are 1-5 years.

  • Yield maintenance – This is a complex prepayment formula based on current interest rates. It aims to ensure the lender receives the same amount of interest over the loan term as originally planned, regardless of early repayment. This often results in substantial penalties.

Knowing the prepayment policy before committing to a DSCR loan is important. Borrowers should negotiate for more flexible options like declining penalties, which allow greater repayment flexibility. Lockout periods and yield maintenance penalties can make it very expensive to refinance or sell the property in the first few years after getting a DSCR loan.

Closing Costs on DSCR Loans

When obtaining a DSCR loan, borrowers can expect to pay closing costs ranging from 2% to 5% of the total loan amount. These fees cover the various administrative, processing, and third-party services necessary to close and fund the loan.

Average Closing Costs as Percentage of Loan

The average closing costs on a DSCR loan tend to fall between 3-4% of the total loan amount. Here is a breakdown of typical closing costs as a percentage of the DSCR loan:

  • Origination Fee – 1-2%
  • Application/Processing Fees – 0.5-1%
  • Appraisal Fee – 0.25-0.5%
  • Credit Report Fee – 0.25%
  • Tax Monitoring Service Fee – 0.1-0.2%
  • Recording Fees – 0.1-0.3%
  • Title Insurance – 0.5-1%
  • Other Third-Party Fees – 0.5-1%

So for a $1 million DSCR loan amount, average closing costs would be around $30,000 to $40,000. Lenders may offer discounts on certain fees for larger loan amounts. It’s important for borrowers to understand these upfront costs when applying for a commercial real estate loan based on debt service coverage ratio.

Alternatives to DSCR Loans

Other Loan Options for Investment Properties

For real estate investors, there are a few alternatives to DSCR loans to consider for financing investment properties:

Conventional Loans – These loans are offered by banks and other private lenders and have more lenient requirements than DSCR loans. You typically need a higher credit score and lower debt-to-income ratio. Down payments are usually 20-25%. Conventional loans can work for some investors, especially if you plan to live in the property for at least a year.

Portfolio Loans – Offered by community banks and credit unions, these loans look at your overall assets and investment portfolio rather than just the property itself. You’ll need strong finances overall, including assets, credit, and cash flow. Portfolio loans provide more flexible qualifying guidelines.

Hard Money Loans – Hard money lenders offer short-term loans for investment properties, based on the property’s value rather than your income or credit. Hard money loans have higher rates and fees but faster approvals. They work as a bridge until you can secure permanent financing.

Owner Financing – With this option, you purchase from a seller who carries the loan themselves. It avoids traditional bank financing requirements but depends on finding a seller willing to offer these terms. Owner financing can provide more flexible qualifying.

Partners/Equity Sharing – Bringing on investment partners can give you added capital to qualify for financing that may be out of reach alone. Equity sharing arrangements split ownership and mortgage obligations. However, you need to fully trust your partners.

For real estate investors who don’t qualify for a DSCR loan, looking at alternative financing options can help you move forward with a property acquisition. The right loan type depends on your financial situation, investment goals, and the specific demands of the property.

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