A property generates annual debt service of $85,000 and has a net operating income of $120,000. What is the debt coverage ratio?
Correct Answer
B) 1.41
Debt coverage ratio = NOI ÷ Annual Debt Service. $120,000 ÷ $85,000 = 1.41.
Why This Is the Correct Answer
Option B is correct because the debt coverage ratio formula is NOI divided by Annual Debt Service. Using the given values: $120,000 (NOI) ÷ $85,000 (Annual Debt Service) = 1.41. This calculation shows the property generates 1.41 times the income needed to cover its debt payments. The ratio of 1.41 indicates strong debt coverage, as it exceeds typical lender requirements of 1.20-1.25.
Why the Other Options Are Wrong
Option A: 0.71
Option A (0.71) represents the inverse calculation - Annual Debt Service divided by NOI ($85,000 ÷ $120,000), which is incorrect and would indicate the property cannot cover its debt obligations.
Option C: 1.18
Option C (1.18) appears to be a miscalculation or confusion with other financial ratios, possibly mixing up components or using incorrect values in the debt coverage ratio formula.
Option D: 0.85
Option D (0.85) is also an incorrect calculation that would suggest the property has insufficient income to cover debt service, which contradicts the actual financial position shown by the given numbers.
NOI Over Debt (NOD)
Remember 'NOD' - NOI Over Debt. Think of 'nodding yes' when the ratio is above 1.0, meaning the property can handle its debt payments.
How to use: When you see a debt coverage ratio question, immediately think 'NOD' and set up the fraction with NOI on top and Annual Debt Service on the bottom, then nod yes if the result is above 1.0.
Exam Tip
Always double-check that you're dividing NOI by debt service, not the reverse - the larger number (NOI) should typically be on top for a healthy property.
Common Mistakes to Avoid
- -Reversing the formula by dividing debt service by NOI
- -Confusing annual debt service with monthly payments
- -Using gross income instead of net operating income
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 ratio 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
The debt coverage ratio is fundamental in commercial real estate analysis and loan underwriting. Appraisers must understand this ratio to properly assess property values using the income approach, as DCR affects financing availability and property marketability.
Real-World Application
Lenders use DCR to determine loan approval and terms. A property with DCR of 1.41 would likely qualify for favorable financing, while a property below 1.20 might face higher interest rates or require additional equity investment.
More Math & Stats Questions
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An irregular lot has the following measurements: Side A = 100', Side B = 150', Side C = 120', Side D = 180'. If the lot can be divided into two rectangles (100' × 150' and 120' × 30'), what is the total area?
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