A property has an annual debt service of $85,000 and a Net Operating Income of $110,000. What is the debt coverage ratio?
Correct Answer
B) 1.29
Debt coverage ratio is calculated by dividing NOI by annual debt service. $110,000 ÷ $85,000 = 1.29.
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: $110,000 ÷ $85,000 = 1.294, which rounds to 1.29. This calculation follows the standard DCR formula where NOI is the numerator and debt service is the denominator. The result of 1.29 indicates that the property's NOI covers the debt service 1.29 times, providing a reasonable safety margin for lenders.
Why the Other Options Are Wrong
Option A: 0.77
Option A (0.77) represents the inverse calculation of debt service divided by NOI ($85,000 ÷ $110,000), which is incorrect and would indicate the property cannot cover its debt obligations.
Option C: 1.77
Option C (1.77) appears to be a calculation error, possibly from incorrectly adding or manipulating the numbers rather than performing the straightforward division of NOI by debt service.
Option D: 0.29
Option D (0.29) seems to be derived from subtracting the inverse ratio from 1.0 (1.00 - 0.77 = 0.23, close to 0.29), which is not the correct method for calculating debt coverage ratio.
NOI Over Debt Service
Remember 'NOI OVER DS' - Net Operating Income goes OVER (divided by) Debt Service. Think of NOI as the 'umbrella' covering the debt service below it.
How to use: When you see a DCR question, immediately identify the NOI (top number) and debt service (bottom number), then visualize the umbrella covering the debt to remember NOI goes on top of the division.
Exam Tip
Always double-check that your DCR result is greater than 1.0 for viable properties - if you get less than 1.0, verify you didn't accidentally flip the formula.
Common Mistakes to Avoid
- -Reversing the formula by dividing debt service by NOI
- -Using gross income instead of Net Operating Income
- -Forgetting to convert monthly debt service to annual or vice versa
Concept Deep Dive
Analysis
The debt coverage ratio (DCR) is a critical financial metric used in real estate investment analysis to measure a property's ability to service its debt obligations. It represents the relationship between a property's Net Operating Income and its annual debt service payments, indicating how many times the property's income can cover its debt payments. A DCR above 1.0 means the property generates sufficient income to cover debt payments, while below 1.0 indicates potential cash flow problems. Lenders typically require a minimum DCR of 1.20-1.25 for commercial real estate loans to ensure adequate cash flow cushion.
Background Knowledge
The debt coverage ratio is fundamental to commercial real estate financing and valuation, as it directly impacts loan approval and terms. Understanding this ratio is essential for appraisers when analyzing income-producing properties and determining their financial viability and risk profile.
Real-World Application
Appraisers use DCR analysis when valuing income properties for lending purposes, helping determine if a property can support proposed financing and assisting in risk assessment for both lenders and investors.
More Math & Stats Questions
What is the area of a triangular lot with a base of 120 feet and a height of 80 feet?
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