It seems more and more likely that we’re heading into a recession. So today, I want to talk about an important metric that investors should keep in mind with the current state of the market: Debt Coverage Ratio (DCR). Joining me to explain this concept is Lon Welsh.
- Listen to the podcast “#397: Protect Yourself in a Recession by Understanding the Debt Coverage Ratio of Your Properties” Denver Real Estate Investing Podcast
- Watch the YouTube video (at the bottom).
- Read the blog post. Note, the blog is an executive summary. Get the in-depth breakdown from the podcast or video.
What is Debt Coverage Ratio?
This is a concept that tends to be overlooked and is less known than other metrics for measuring a property’s financial success. However, if there’s any point in the economic cycle that investors should be thinking about debt coverage ratio, it’s now.
To understand what a DCR is, look at one of your rental properties and take the gross rent collected minus vacancy to calculate your collected rent. Subtract out all the operating expenses and you have your Net Operating Income (NOI). If you have no mortgage and strong reserves, that would be your cash flow.
However, most people have debt in the form of a mortgage, so to find your debt coverage ratio, divide your annual NOI by the debt service (the annual amount of cash needed to pay off your principal and interest), and that is your debt coverage ratio. For example, if your property generates $12K in cash flow, and your debt service is $10K, your debt coverage ratio is 1.2, or 120%.
This calculation works for almost every asset class: condo, house, multifamily, even apartment buildings and commercial properties. It’s often an afterthought in residential real estate, but banks put a lot of weight into DCR for commercial properties.
Why Do I Need to Know about Debt Coverage Ratio?
DCR is an important concept because it’s a measure of financial safety. The larger your DCR, the safer your property is. If you need to lower rents in a recession or have many maintenance disasters at once that cost more than your reserves, you know you’ll have the financial resilience to weather the storm.
Investors want at least 120% DCR, but the higher the number the better. In a recession, 130% is a good amount that will help you sleep at night.
Should I Assess DCR Across My Portfolio or Just New Properties?
DCR should really be calculated for both your entire portfolio and to assess new properties you want to purchase.
For a typical investor who bought a house or condo four years ago and hasn’t done a refinance, the property may be worth 60-70% more today. Since the mortgage rate is unchanging and interest rates have been low, their DCR is likely very attractive. Meanwhile, rents have gone up a huge amount over that same four year period, which means the DCR gets a little better every year.
If you’re thinking about doing a refinance on a Denver property, you may find that your property is worth so much money you have the ability to take out a substantial amount of cash. Make sure that before you take out the max amount that your DCR won’t be too skinny. This could lead to you being uncomfortably tight on cash, especially as we head into a recession. It’s important to leave some cash in the property, or put it aside in a reserve to serve as a cushion.
Learn More About DCR
As we head into a recession, make sure to look at the DCR of your properties. If you have any questions on this topic, reach out to Lon or me and we’d be happy to give you more information.