A property has net operating income of $85,000 and annual debt service of $68,000. What is the debt coverage ratio?
Correct Answer
B) 1.25
Debt Coverage Ratio = Net Operating Income ÷ Annual Debt Service. $85,000 ÷ $68,000 = 1.25.
Why This Is the Correct Answer
Option B (1.25) is correct because it follows the standard DCR formula: Net Operating Income ÷ Annual Debt Service. Calculating $85,000 ÷ $68,000 = 1.25, which means the property generates 25% more income than needed to cover debt payments. This ratio indicates healthy cash flow and meets typical lender requirements for commercial financing.
Why the Other Options Are Wrong
Option A: 0.8
Option A (0.8) represents the inverse calculation (Annual Debt Service ÷ Net Operating Income), which would indicate the property cannot cover its debt obligations since the ratio is below 1.0.
Option C: 0.125
Option C (0.125) appears to be a decimal error, possibly from dividing the difference between NOI and debt service by NOI, which is not the correct DCR formula.
Option D: 1.8
Option D (1.8) is mathematically incorrect and may result from incorrectly manipulating the given numbers or using an entirely different calculation method.
NOI Over Debt (NOD)
Remember 'NOD' - Net Operating Income goes 'over' (divided by) Debt service. Think of NOI as the 'boss' sitting above debt service, showing how well income covers the debt obligation.
How to use: When you see DCR questions, immediately think 'NOD' and put NOI on top of the fraction, debt service on bottom. This prevents the common error of inverting the formula.
Exam Tip
Always double-check that your DCR result is greater than 1.0 for financially healthy properties - if you get less than 1.0, you likely inverted the formula.
Common Mistakes to Avoid
- -Inverting the formula (debt service ÷ NOI)
- -Using gross income instead of net operating income
- -Confusing annual debt service with monthly 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 in commercial real estate financing and valuation, as it directly impacts loan approval and property value. Appraisers must understand this metric because it affects the income approach to valuation and helps determine appropriate capitalization rates.
Real-World Application
Lenders use DCR to determine loan approval and terms. A property with DCR of 1.25 means for every $1 of debt service, the property generates $1.25 of NOI, providing a 25% safety margin that reassures lenders about repayment capability.
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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