When it comes to investing in real estate, securing the right type of financing plays a crucial role in any successful transaction. This principle holds even more truth for investors aspiring to venture into the short-term rental space—a burgeoning sector in today’s real estate industry.
The available options for financing are varied, encompassing traditional loans, hard money loans, or even loans sourced from personal connections. However, in this comprehensive guide, our focus shifts toward an incredibly powerful tool for scaling your real estate portfolio: DSCR loans.
What Are DSCR Loans?
A DSCR loan, short for debt service coverage ratio, is a type of loan that is primarily underwritten and qualified based on the revenue of the subject property. Unlike more traditional types of financing that focus on the borrower’s individual income (like W-2s, tax returns, and personal debt-to-income ratios), DSCR loans adopt a different approach. They focus primarily on the income or projected cash flow that the property in question generates. The primary underwriting question is whether the property’s income can cover the cost of ownership, mainly the principal, interest, property taxes, insurance, and HOA fees—collectively known as PITIA—linked with the new loan.
Let’s break this down with a simple example: Assume a property is expected to generate gross monthly revenue of $10,000, and the PITIA associated with the new loan amounts to $5,000. By dividing the projected income by the PITIA ($10,000/$5,000), we get a DSCR of 2.00. This figure is representative of the property’s ability to meet its debt obligations.
Generally, most DSCR loans need a minimum of 1.00x DSCR in order to qualify, with the best rates and terms available to DSCR loans of 1.25-plus. It is even possible in certain scenarios for a DSCR loan to be approved when the DSCR ratio is below 1.00x.
In short, DSCR loans can be a powerful tool in the toolbox of any short-term rental investor. By allowing investors to secure financing on the property’s income, these loans eliminate potential personal income-related hurdles and pave the way for portfolio expansion. However, a thorough understanding of the different types of income applicable to DSCR loans is necessary to leverage their full potential.
What Types of Income Are Used to Qualify?
When evaluating any potential short-term rental, it’s crucial to understand the different types of income that the property may have and how a DSCR lender may use that income in order to underwrite and qualify the loan. Here are some factors lenders look at.
Trailing-12-month income statement (TTM)
Typically, the first type of income a lender will look for when evaluating a short-term rental is the historical income the property has generated through past operations. This form of income is commonly known as a trailing 12-month or TTM income statement, which represents the income generated over the last 12 months of operations. If you are considering a property for purchase or refinance that has this historical data, a lender can use this information to calculate the DSCR and potentially approve the loan.
However, not all potential properties have a historical operating history, particularly when the previous owners did not use the property as a short-term rental. In such cases, projected income can fill this void.
Today’s marketplace offers several data services, like AirDNA and Rabbu, that can provide reliable income projections for properties operating as short-term rentals. While there are many DSCR lenders available to investors, only a small percentage of those lenders acknowledge these projections and can use them for the loan approval process, so it is important to shop wisely and ask the right questions regarding the income a lender will use for underwriting.
One thing to consider when looking at a property’s short-term rental-based income—whether it be historical TTM income or projected income—is the expense factor. Operating expenses for short-term rentals are often higher than those for long-term rentals, and lenders typically account for this by applying an expense factor, typically anywhere from a 20% to 25% reduction to gross rental income, before running the DSCR calculation.
Using our previous example, if a property has a monthly projected short-term rental income of $10,000 and a 20% expense factor is applied, the effective income drops to $8,000. We then divide this effective income by the $5,000 PITIA, and we get $8,000/$5,000, resulting in a DSCR of 1.60.
That said, expense factors are not fixed rules across the lender spectrum, and not all DSCR lenders will utilize them in the same way or at the same percentages. It is even possible for experienced short-term rental investors to not have expense factors applied at all, which means they can use 100% of a property’s income to qualify.
1007 rental survey
Another method for underwriting a DSCR loan is with the rental income determined by the appraiser during the appraisal process. All DSCR loans require an appraisal to include a 1007 market rental income survey report. This report provides an estimate of the property’s potential income if it were to be leased out on a traditional 12-month basis.
However, this approach could present a challenge, as the 1007 market rental income is often significantly less than the potential short-term rental income of a property, making it difficult to reach the necessary DSCR thresholds to qualify. In specific cases, the 1007 rental survey can be completed with consideration of the rental income generated as a short-term rental. Note that this approach is the topic of ongoing discussion within the appraisal community, as it challenges the conventional use of the 1007 form.
Not All Lenders Are Created the Same. Shop Savvy.
Now that we understand how DSCR loans work and the types of property income that can be used to qualify, here are some due diligence questions to ask when shopping for potential lenders.
As mentioned, not all DSCR lenders view short-term rentals the same way, despite many claiming to be able to finance short-term rentals. While a DSCR lender may, in some cases, be able to finance an STR, it’s usually only when market rents qualify, as this is the standard income used for many DSCR lenders.
To ensure you have the full suite of income options and prevent changing terms during underwriting (such as loan size reduced due to a lesser-than-expected income being used, rates increasing due to falling in a lower DSCR bracket, etc.), you want to ask your potential lending partners the following questions:
What type of income did you use to quote this property?
Any lender that uses projected STR income can also use market rents to qualify, but the other way around is less likely to be true. It is important to know your lender can use market rents, TTM income, or projections to qualify a loan.
Are you able to use projections from AirDNA or Rabbu to qualify for this loan?
If the lender states they are using market rents to qualify your loan, as it will get you a lower rate, you will want to know what happens if the 1007 market rent survey comes back lower than expected. Can the lender use short-term rental income projections to qualify? If so, how would the terms change? It’s important to know the answers to these questions.l You don’t want to risk a higher rate or losing your earnest money deposit, should terms change significantly after the appraisal report comes back.
Are leases required at any time during the underwriting process or after the loan closes?
This should be fairly obvious, but short-term rentals, by their nature, do not have leases in place. And although some DSCR lenders will say they can finance the purchase or even refinance vacant properties, they may have an underwriting condition that requires a lease before or after closing. You want to make sure you have the answer to this question before starting the application process with any lender.
Does underwriting know the intended use of this property as an STR?
Some loan officers will try their best to use what limited tools they have to close a deal. Sometimes that means trying to qualify with market rents, even if their guidelines strictly say “no STRs allowed, period.” Can’t blame them for trying, but this is why we shop savvy.
What if my property is appraised as a “rural” market?
Many of the best-performing short-term rental properties are in areas considered “rural” on an appraisal. Be sure to ask your lender whether any of the loan terms initially quoted would change if your property comes back with this rural designation. With many typical DSCR lenders not familiar with short-term rentals, there can often be a reduction in leverage, an increase in the rates, or a denial of the loan altogether if the property is designated rural on the appraisal.
Other Advantages of DSCR Loans Over Other Types of Financing
In addition to being able to use the income of the property as the primary underwriting and qualification method, DSCR loans offer investors many other advantages over other more traditional types of financing, including the following.
Closing in an entity
DSCR loans can be vested in an entity—typically an LLC or corporation. This allows the borrower to keep the loan off their personal credit report, thereby not impacting their personal debt-to-income ratio. This arrangement offers other advantages, such as the ability to bring on minority or “limited partners” who can act as investors in a deal without having to be a personal guarantor on the loan.
Pro tip: If you are considering bringing on a limited partner for a deal, be sure to keep the ownership percentage in the entity below 20% for any individual investor if that investor does not want to be a guarantor on the loan.
No limit on the number or dollar value of DSCR loans
Unlike conventional loans backed by Fannie Mae or Freddie Mac, DSCR loans do not have a limit on the number or the total dollar value of DSCR loans that a borrower can have. This allows an investor to continue to scale their portfolio if each new property is generating enough income to qualify for the DSCR loan.
Potentially higher loan amounts and LTVs
Similarly, since the loan is underwritten based on the cash flow of the property, an investor may be able to secure significantly higher loan amounts and LTV (loan-to-value) ratio than they might if they were qualifying for a more conventional type of financing based on personal income.
DSCR loans are a potentially invaluable tool for real estate investors looking to break into or expand within the short-term rental market. By shifting the underwriting focus from the investor’s personal income to the income generated by the property, these loans offer a unique opportunity for portfolio growth.
With an in-depth understanding of DSCR loans, their advantages, and their underwriting process, investors can make informed decisions and maximize their chances of success in the real estate industry. As with any financial venture, due diligence, research, and careful planning are critical to success. Harnessing the power of DSCR loans could pave the way to a prosperous future for the short-term rental investor.
As you progress in your real estate investment journey, always remember the golden rule: Knowledge is power. Equip yourself with a thorough understanding of DSCR loans and leverage them effectively. You may soon find yourself on the fast track to significant portfolio growth and success in the short-term rental market.