A debt coverage ratio of 1.25 means:
Correct Answer
D) NOI is 1.25 times the annual debt service
Why this is correct: The Debt Coverage Ratio (DCR) measures the cushion of Net Operating Income over annual debt service. DCR = NOI / Annual Debt Service. A DCR of 1.25 means NOI is 125% of the debt service. Why the other choices are wrong: "The property's expenses are 125% of income" describes an expense ratio >100%, which is not sustainable. "The loan covers 125% of the purchase price" describes a Loan-to-Value ratio >100%, which is atypical. "Equity earns 25% more than the debt does" misinterprets the ratio; it compares NOI to debt service, not equity return to debt return. Exam tip: DCR = NOI / Debt Service. Lenders require a minimum DCR (e.g., 1.20) as a safety cushion.
Why This Is the Correct Answer
The debt coverage ratio is net operating income divided by annual debt service, so 1.25 means income is 1.25 times the debt payment — a 25 percent cushion.
Why the Other Options Are Wrong
Option A: The property's expenses are 125% of income
An expense ratio compares operating expenses to income and is a different measure entirely.
Option B: The loan covers 125% of the purchase price
The relationship between loan amount and price is the loan-to-value ratio, not the debt coverage ratio.
Option C: Equity earns 25% more than the debt does
The ratio compares income to debt service, not returns to equity against returns to debt.
Income Over Payment
Income Over Payment. One point two five means twenty-five cents of cushion on every dollar owed.
How to use: Remember NOI is the numerator. Reversing it produces a number below one and reverses the meaning.
Exam Tip
The debt coverage requirement often limits loan size before the loan-to-value limit does, because it is driven by income rather than value.
Common Mistakes to Avoid
- -Inverting the ratio
- -Confusing it with loan-to-value or expense ratio
- -Using cash flow after debt service in the numerator
Concept Deep Dive
Analysis
The debt coverage ratio measures whether a property's earnings can service its debt with room to spare. It is net operating income divided by annual debt service, so a ratio of 1.25 means the property generates $1.25 of net operating income for every dollar of debt payment — a 25 percent cushion against a decline in income before the loan cannot be paid from operations. Lenders set minimum ratios as an underwriting condition, commonly around 1.20 to 1.30 for stabilised commercial property, and the requirement often binds before the loan-to-value limit does: a property may support a high value while its income supports only a smaller loan. For the appraiser the ratio matters in two ways. It appears in the band-of-investment and debt coverage formula methods of deriving a capitalization rate, and it explains why a buyer's financing capacity is limited by income rather than by value.
Background Knowledge
Debt coverage ratio is net operating income divided by annual debt service. Lenders set minimum ratios as underwriting conditions, and the ratio is used in deriving capitalization rates through the debt coverage formula.
Real-World Application
An appraiser notes a lender's 1.25 minimum coverage requirement caps the supportable loan below what the loan-to-value limit would allow.
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