A property generates NOI of $60,000 and has annual debt service of $45,000. If the loan amount is $400,000, what is the debt coverage ratio?
Correct Answer
C) 1.33
Why this is correct: The Debt Coverage Ratio (DCR) measures a property's ability to cover its annual mortgage payments from its Net Operating Income (NOI). The formula is DCR = NOI / Annual Debt Service. Applying the numbers: DCR = $60,000 / $45,000 = 1.333..., which rounds to 1.33. A DCR above 1.0 indicates sufficient income to cover the debt payment. The loan amount ($400,000) is not used in the DCR calculation. Why the other choices are wrong: "8.89" might result from dividing NOI by the loan amount ($60,000/$400,000=0.15) or another incorrect operation. "0.75" is the inverse of the correct ratio (Debt Service/NOI). "1.50" is not the result of the correct division. Exam tip: DCR = NOI / Debt Service. Memorize this ratio; it's crucial for income property analysis and lender requirements.
Why This Is the Correct Answer
Option A is correct because the debt coverage ratio is calculated by dividing NOI by annual debt service: $60,000 ÷ $45,000 = 1.33. This straightforward division gives us the multiple of income coverage over debt obligations. The result of 1.33 means the property generates 33% more income than required to service the debt, which is generally considered acceptable by most lenders. The loan amount of $400,000 is irrelevant to this calculation as DCR only considers income flow versus debt service payments.
Why the Other Options Are Wrong
Option A: 8.89
Option A (8.89) likely results from incorrectly dividing the loan amount by annual debt service ($400,000 ÷ $45,000), which has no relevance to debt coverage ratio calculations. The loan principal amount is not used in DCR calculations, only the annual payment amount matters.
Option B: 0.75
Option B (0.75) represents the inverse calculation of annual debt service divided by NOI ($45,000 ÷ $60,000), which would be the debt service coverage percentage rather than the debt coverage ratio. This would incorrectly suggest the property cannot cover its debt obligations, when in fact it can.
Option D: 1.50
Option D (1.50) appears to be a miscalculation, possibly from rounding errors or using incorrect figures in the formula. While 1.50 would represent an excellent debt coverage ratio, it doesn't match the actual calculation of $60,000 ÷ $45,000 = 1.33.
NOI Over Debt = Coverage Ahead
Remember 'NOI OVER DEBT' - Net Operating Income goes on top, Debt service on bottom. Think 'Coverage Ahead' when the result is above 1.0, meaning you're covered and ahead of your debt obligations.
How to use: When you see DCR questions, immediately identify NOI (top number) and annual debt service (bottom number). Ignore loan amounts or other figures. If the result is above 1.0, the property has positive coverage.
Exam Tip
Always double-check that you're using annual debt service, not monthly payments or loan principal amounts. The question will often include irrelevant numbers like loan amounts to test your understanding of the formula.
Common Mistakes to Avoid
- -Using loan principal amount instead of annual debt service
- -Calculating the inverse ratio (debt service ÷ NOI)
- -Using monthly debt service instead of annual debt service
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 generate sufficient income to cover its debt obligations. It measures the relationship between a property's Net Operating Income (NOI) and its annual debt service payments. A DCR above 1.0 indicates the property generates more income than needed 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, making this ratio essential for loan underwriting and property valuation.
Background Knowledge
Debt Coverage Ratio is calculated as NOI ÷ Annual Debt Service and measures a property's ability to pay its debt obligations from operating income. Commercial lenders typically require DCR of 1.20 or higher, with 1.25-1.30 being preferred for most property types.
Real-World Application
Appraisers use DCR to assess investment property values and help lenders determine loan approval. A property with DCR below 1.20 might require higher down payments or be rejected for financing, directly affecting market value and marketability.
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