A property has annual debt service of $85,000 and net operating income of $110,000. What is the debt coverage ratio?
Correct Answer
A) 1.29
Debt coverage ratio is calculated as NOI ÷ Annual Debt Service. $110,000 ÷ $85,000 = 1.29.
Why This Is the Correct Answer
Option A is correct because the debt coverage ratio formula is NOI divided by Annual Debt Service. Using the given figures: $110,000 (NOI) ÷ $85,000 (Annual Debt Service) = 1.294, which rounds to 1.29. This calculation follows the standard financial formula used throughout the real estate industry. The result of 1.29 indicates the property generates 29% more income than needed to cover debt payments, which is generally considered acceptable by most lenders.
Why the Other Options Are Wrong
Option B: 0.77
Option B (0.77) represents the inverse calculation of Annual Debt Service divided by NOI ($85,000 ÷ $110,000 = 0.77). This is a common error where students flip the formula components. A DCR of 0.77 would indicate the property only generates 77% of the income needed to cover debt service, which would be unacceptable to lenders.
Option C: 1.94
Option C (1.94) appears to be a calculation error, possibly from incorrectly manipulating the numbers or using wrong figures. No logical mathematical operation using the given NOI of $110,000 and debt service of $85,000 would yield 1.94. This might result from adding instead of dividing or using incorrect base numbers.
Option D: 25,000
Option D (25,000) represents the simple subtraction of Annual Debt Service from NOI ($110,000 - $85,000 = $25,000). While this shows the excess cash flow after debt service, it is not the debt coverage ratio, which must be expressed as a ratio or decimal, not a dollar amount.
NOI Over Debt (NOD)
Remember 'NOD' - NOI Over Debt. Think of nodding your head 'yes' when the ratio is above 1.0, meaning the property can cover its debt. The acronym NOD helps you remember that NOI goes on top (numerator) and Debt service goes on bottom (denominator).
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. If the result is above 1.0, nod yes - the property covers its debt adequately.
Exam Tip
Always double-check that your DCR result makes logical sense - it should typically be between 1.0 and 2.0 for most commercial properties. If you get a number below 1.0 or above 3.0, review your calculation as you may have flipped the formula.
Common Mistakes to Avoid
- -Flipping the formula and dividing debt service by NOI instead of NOI by debt service
- -Using gross income instead of net operating income in the calculation
- -Confusing annual debt service with monthly payments or principal-only payments
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. This ratio measures the relationship between a property's net operating income and its annual debt service payments. A DCR above 1.0 indicates the property generates more income than required to service its debt, while a ratio 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 to commercial real estate financing and valuation, as it directly impacts a property's financing capacity and risk assessment. Appraisers must understand this metric because it affects property values through the income approach and helps determine appropriate capitalization rates and financing assumptions.
Real-World Application
Appraisers use DCR when analyzing comparable sales that were purchased with financing, when estimating the impact of financing on property values, and when preparing feasibility studies for proposed developments. Lenders require DCR analysis in appraisal reports for loan underwriting decisions.
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?
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?
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