A property generates NOI of $75,000 and has annual debt service of $60,000. What is the debt coverage ratio?
Correct Answer
B) 1.25
Debt coverage ratio = NOI ÷ Annual debt service. $75,000 ÷ $60,000 = 1.25.
Why This Is the Correct Answer
Option B is correct because the debt coverage ratio is calculated by dividing Net Operating Income by Annual Debt Service. Using the given figures: $75,000 (NOI) ÷ $60,000 (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 or considerations needed.
Why the Other Options Are Wrong
Option A: 0.80
Option A (0.80) represents the inverse calculation - dividing debt service by NOI ($60,000 ÷ $75,000), which would be the debt service coverage burden rather than the debt coverage ratio.
Option C: 1.20
Option C (1.20) appears to be a common target DCR that lenders prefer, but it's not the actual calculated ratio for this specific property's financial performance.
Option D: 0.75
Option D (0.75) is incorrect and doesn't correspond to any logical calculation using the given NOI and debt service figures in either direction.
NOI Over Debt = Coverage Ahead
Remember 'NOI OVER DEBT' - always put Net Operating Income on top (numerator) and debt service on bottom (denominator). Think 'Coverage' means how much the income 'covers' or goes 'over' the debt obligation.
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 'covers' its debt; below 1.0 means trouble.
Exam Tip
Always double-check that you're dividing NOI by debt service, not the reverse - this is the most common error on DCR questions and will give you an answer that's the reciprocal of the correct one.
Common Mistakes to Avoid
- -Dividing debt service by NOI instead of NOI by debt service
- -Confusing annual debt service with monthly payments
- -Using gross income instead of net operating income in the calculation
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 cushion for loan approval.
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 the mortgage loan. The debt coverage ratio is a key underwriting criterion that lenders use to evaluate loan risk and determine loan approval.
Real-World Application
Appraisers use DCR analysis when valuing income-producing properties for lending purposes, helping determine if the property can support proposed financing and assisting in the overall risk assessment for mortgage underwriting decisions.
More Math & Stats Questions
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