A property generates annual NOI of $75,000 and annual debt service of $60,000. What is the debt coverage ratio?
Correct Answer
A) 1.25
Debt coverage ratio is calculated as NOI ÷ Annual Debt Service. $75,000 ÷ $60,000 = 1.25.
Why This Is the Correct Answer
Option A is correct because the debt coverage ratio formula is straightforward: NOI divided by Annual Debt Service. With an NOI of $75,000 and annual debt service of $60,000, the calculation is $75,000 ÷ $60,000 = 1.25. This ratio of 1.25 means the property generates 25% more income than needed to cover debt payments, which meets typical lender requirements. The result indicates healthy cash flow with adequate coverage for debt obligations.
Why the Other Options Are Wrong
Option B: 0.80
Option B (0.80) represents the inverse calculation of debt service divided by NOI ($60,000 ÷ $75,000), which is incorrect and would indicate the property cannot cover its debt obligations.
Option C: 1.80
Option C (1.80) appears to be a miscalculation, possibly confusing this ratio with other financial metrics or incorrectly manipulating the given numbers.
Option D: 0.25
Option D (0.25) represents the excess coverage amount ($15,000 ÷ $60,000) rather than the total coverage ratio, which is not how DCR is calculated.
NOI Over Debt = Coverage Spread
Remember 'NOI OVER DEBT' - NOI goes on top (numerator), Debt service goes on bottom (denominator). Think of it as 'How many times can my NOI cover my debt?' The answer should be greater than 1 for positive coverage.
How to use: When you see a DCR question, immediately identify the NOI and annual debt service, then set up the fraction with NOI on top. If the result is above 1.0, the property has positive coverage; if below 1.0, it has negative coverage.
Exam Tip
Always double-check that you're dividing NOI by debt service, not the reverse. The correct answer should typically be above 1.0 for viable commercial properties, which can help you eliminate obviously wrong answers.
Common Mistakes to Avoid
- -Calculating debt service ÷ NOI instead of NOI ÷ debt service
- -Using gross income instead of Net Operating Income
- -Confusing DCR with other ratios like loan-to-value or capitalization rates
Concept Deep Dive
Analysis
The Debt Coverage Ratio (DCR) is a critical financial metric used by lenders to assess the risk of a commercial real estate loan. It measures a property's ability to generate sufficient income to cover its debt obligations by comparing the Net Operating Income to the annual debt service payments. A DCR above 1.0 indicates the property generates more income than required for debt payments, while below 1.0 suggests potential cash flow problems. Most commercial lenders require a minimum DCR of 1.20-1.25 to approve financing, as this provides a safety cushion for income fluctuations.
Background Knowledge
Net Operating Income (NOI) represents the property's annual income after operating expenses but before debt service and taxes. Annual debt service includes both principal and interest payments on all property-related loans. Understanding the relationship between these figures is essential for evaluating investment property performance and loan qualification.
Real-World Application
Lenders use DCR to determine loan approval and terms. A property with DCR of 1.25 would likely qualify for financing, while one with 0.80 would be rejected. Appraisers must understand DCR when analyzing comparable sales and determining how financing affects property values in the market.
More Math & Stats Questions
What is the area of a triangular lot with a base of 120 feet and a height of 80 feet?
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?
A property has a potential gross income of $180,000, vacancy and collection loss of 7%, and operating expenses of $65,000. What is the NOI?
A property generates $120,000 in net operating income and is valued at $1,500,000. What is the capitalization rate?
A building has potential gross income of $180,000, vacancy and collection loss of 8%, and operating expenses of $54,000. What is the net operating income?
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