When starting your portfolio, the banks will look heavily at your ability as a borrower to service any loans they provide, with minimal focus on the property itself. During this critical startup phase where you remain in the spotlight, it is important to understand and manage your ratios carefully. Doing so will allow you to get further along before hitting the proverbial “financing wall”.
Ratio #1: GDS (Gross Debt Service)
Guideline: < 30-32%
The Gross Debt Service Ratio represents the percentage of the borrower’s income required to cover payments for all required monthly housing costs. These costs consist of mortgage principal and interest, property taxes, and depending on the lender may also include secondary financing, heating, condominium fees. Lenders perceive a higher GDS ratio to be more risky, as the borrower will have to stretch further to service their debts.
GDS Ratio = (Mortgage P&I + Property Taxes + Heating + Condo Fees) / Borrower’s Income
It doesn’t take a math whiz to figure out that this ratio could be limiting to most investors looking to build a portfolio of rental properties. Even with an income of $100,000 per year, you’d need to keep your monthly housing costs below $2,500 to keep your GDS below 30%. One point of consolation is that lenders will generally consider your rental income to your when calculating your GDS ratio. We will examine this further in Debt Ratios 201: Rental Offset vs Rental Add Back.
Ratio #2: TDS (Total Debt Service)
Guideline: < 40%
The Total Debt Service Ratio is very similar to the GDS ratio, but it considers all other debt obligations in addition to your required monthly housing costs. In calculating your TDS ratio you’ll need to add in car payments, student loan payments, credit cards payments and any other debt obligations you may have. As with GDS, a higher TDS ratio represents more risk to the lender, so a lower ratio is better here as well.
TDS Ratio = (Mortgage P&I + Property Taxes + Heating + Condo Fees + Car, Credit Card & Loan Payments) / Borrower’s Income
GDS is usually the limiting factor, but depending on your other obligations, TDS can come into play. Be careful about taking on other debts or leasing a new car before talking to your mortgage broker and determining how you’ll be able to finance your next property. If you simply can’t resist taking on the additional payments, be sure all of those payments remain less than 8% of your income so your TDS ratio doesn’t become a limiting factor.
Ratio #3: DCR (Debt Coverage Ratio)
Guideline: > 1.1
Also known as the Debt Service Coverage Ratio (DSCR), this ratio measures your ability to service your debt by making monthly payments based on the cash generated by your portfolio. This ratio looks at the strength of the property or portfolio rather than your personal strength as the borrower. While this has become less important in the eyes of lenders over the past year, it is still a good guideline to follow when building your portfolio.
DCR = Net Operating Income (NOI) / Debt Service
Whether calculated on an annual or monthly basis, NOI is your gross rental income less all expenses other than debt service. Each lender may have their own guidelines for calculating NOI but you’ll need to subtract vacancy, maintenance, insurance, and management expenses as well as any condo fees to derive your net operating income. Debt service is simply the payment (both principal and interest) due on any mortgage financing for the property or portfolio.
Although the magical 1.1 DCR rule may no longer open the doors to all the financing you need, it will help you select cash flowing properties and position you well for when you are able to qualify for portfolio financing.
Assuming we had the down payments available when starting our portfolios, few of us have enough income from a salaried day job to keep our ratios in line while buying all the real estate we want. More often than not, the GDS ratio will end up being a frustrating obstacle on the path to achieving our financial goals.
To overcome the roadblock ratios can present we need to engage in win-win relationships with others, manage our ratios carefully until we can be considered for portfolio financing, or start shifting our focus to multi-family investing. If you haven’t already added a great mortgage broker to your real estate investment team, don’t wait any longer. An investor savvy mortgage broker will be able to help you understand these ratios, how they come into play in your personal financial situation, and help you plan out the right steps for financing your future purchases.
photo credit: CarbonNYC
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