Debt Service Coverage (DSC), also known as Debt Service Coverage Ratio (DSCR), is the proportion of cash available to borrowers for lease, principal, and interest payments. Used as a benchmark by traditional real estate lenders, DSC measures the ability of an entity (corporation or individual) to produce enough funds to make your loan payments within the promised time frame. The first thing a bank asks is your DSC ratio when applying for bank financing on an income property. This means you can easily get commercial financing on an income property from a bank if your DSC ratio is high.
Investors often find excellent investment opportunities in leased and even vacant properties, but these properties have the DSCR that banks need. In such cases, investors tend to work with reputable hard money lenders who offer them an interest reserve in order to overcome the bank’s DSCR requirements. These types of financing opportunities are not found with traditional financial lenders.
How does the interest reserve work?
Suppose you make loan payments of $1,800 per month and want to apply for a bank loan for an income property. In case your rental income from the property is less than or equal to $1800, it is impossible for you to get your loan approved. You should contact bridging loan lenders who can provide you with an interest reserve.
Suppose you have purchased a property that is only 50% leased. But you want to apply for a bank loan because you don’t have enough debt service coverage to get your loan approved. To pass the DSC requirements, you contact a well-known lender who offers you $1,000,000 in financing for your purchase. However, the lender deposits $100,000 into an escrow account to allow you the funds to make the monthly payments. The lender pays $10,000 from the account over 10 months to make the required payments.
While the lender is busy making the monthly payments, the landlord is looking for a tenant to rent the vacant space. In most cases, the income property is leased 100% at the end of 10 months and the borrower has sufficient income to make the loan payments. Borrowers now have no need to withdraw from the interest reserve to make monthly payments.
What are the benefits of using the interest reserve?
You have to pay considerably less to buy a vacant or 50% leased property. Once the property is 100% leased due to the interest reserve, it is worth considerably more and also qualifies for a traditional/conventional bank loan. When the property owner refinances the hard money loan with the bank, he gets a lower traditional bank rate. It is vital to understand that without working with a reputable and reputable hard money lender, the property owner would have found it extremely difficult to acquire the property in the first place and would also have missed out on an excellent investment opportunity.
