A property generates $85,000 in NOI and has annual debt service of $68,000. What is the debt coverage ratio?
Correct Answer
D) 1.25
Why this is correct: The Debt Coverage Ratio (DCR) is calculated by dividing the property's annual Net Operating Income (NOI) by its annual debt service (mortgage payment). This ratio indicates how many times the NOI covers the debt obligation. Applying the formula: DCR = $85,000 / $68,000 = 1.25. A DCR of 1.25 means the property generates 25% more income than needed to pay the debt. Why the other choices are wrong: "1.80" is not the result of the given division. "0.25" is the result of a different calculation, perhaps (Debt Service - NOI) / NOI. "0.80" is the inverse ratio (Debt Service/NOI), which is not the standard DCR. Exam tip: Always use the formula DCR = NOI / Debt Service. Lenders typically require a minimum DCR, often 1.20 or higher, to ensure a safety cushion.
Why This Is the Correct Answer
Option A is correct because the debt coverage ratio formula is NOI divided by annual debt service. Taking $85,000 (NOI) ÷ $68,000 (annual debt service) = 1.25. This means the property generates 1.25 times the income needed to cover its debt payments. The calculation is straightforward division with no additional adjustments needed.
Why the Other Options Are Wrong
Option A: 1.80
Option A (1.80) appears to be a miscalculation, possibly from incorrectly manipulating the numbers or confusing this with another financial ratio. No standard calculation using the given figures would yield 1.80.
Option B: 0.25
Option B (0.25) represents an incorrect calculation that doesn't follow any logical mathematical relationship between the NOI and debt service figures provided. This may result from calculation errors or formula confusion.
Option C: 0.80
Option C (0.80) represents the inverse calculation of debt service divided by NOI ($68,000 ÷ $85,000), which would be the debt service coverage percentage rather than the debt coverage ratio. This common error reverses the numerator and denominator.
NOI Over Debt
Remember 'NOI Over Debt' - NOI goes on top (numerator), Debt service goes on bottom (denominator). Think 'How many times does my NOI cover my Debt?'
How to use: When you see a debt coverage ratio question, immediately write the fraction with NOI on top and annual debt service on bottom, then divide to get your answer above 1.0 for healthy properties.
Exam Tip
Always double-check that your DCR answer makes logical sense - it should typically be above 1.0 for viable income properties, and most lenders require 1.20 or higher.
Common Mistakes to Avoid
- -Reversing the formula by putting debt service over NOI
- -Using gross income instead of NOI in the calculation
- -Forgetting to include all components of annual debt service (principal + interest)
Concept Deep Dive
Analysis
The debt coverage ratio (DCR) is a critical financial metric used by lenders and appraisers to assess a property's ability to service its debt obligations. It measures how many times the property's net operating income can cover the annual debt service payments. A DCR above 1.0 indicates the property generates sufficient income to cover debt payments, while below 1.0 suggests potential cash flow problems. Lenders typically require a minimum DCR of 1.20-1.25 for commercial properties to ensure adequate cash flow cushion.
Background Knowledge
Net Operating Income (NOI) represents a property's gross income minus operating expenses, but before debt service and taxes. Annual debt service includes both principal and interest payments made on the property's mortgage throughout the year.
Real-World Application
Appraisers use DCR analysis when valuing income properties to assess financial viability and risk. Lenders review DCR during underwriting to ensure borrowers can service debt, and property managers monitor DCR to evaluate operational performance and refinancing opportunities.
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