An income property generates annual NOI of $85,000 and has annual debt service of $68,000. What is the debt coverage ratio?
Correct Answer
A) 1.25
Why this is correct: Debt Coverage Ratio (DCR) = Net Operating Income ÷ Annual Debt Service. Calculation: $85,000 ÷ $68,000 = 1.25. Why the other choices are wrong: 1.80 would result from dividing debt service by NOI ($68,000 ÷ $85,000). 0.25 is one-fourth of the correct ratio. 0.80 would imply NOI is less than debt service, indicating negative cash flow. Exam tip: DCR = NOI / Debt Service. A ratio above 1.0 means income covers debt; lenders often require at least 1.20.
Why This Is the Correct Answer
Option A is correct because the DCR formula is straightforward: NOI divided by Annual Debt Service. Using the given figures: $85,000 ÷ $68,000 = 1.25. This calculation shows that the property generates 1.25 times the income needed to cover its debt service, meaning there's a 25% cushion above the minimum required to pay the debt. A DCR of 1.25 exceeds most lenders' minimum requirements and indicates healthy cash flow coverage.
Why the Other Options Are Wrong
NOI Over Debt = Coverage Spread
Remember 'NOD' - NOI Over Debt = DCR. Think of it as 'How many times can NOI cover the debt?' The bigger the number, the better the coverage.
How to use: When you see a DCR question, immediately identify NOI (the numerator) and annual debt service (the denominator), then think 'NOD' to remember the correct formula direction.
Exam Tip
Always double-check that you're dividing NOI by debt service, not the reverse. A DCR above 1.0 should make intuitive sense - the property must generate more income than its debt payments.
Common Mistakes to Avoid
- -Dividing debt service by NOI instead of NOI by debt service
- -Using monthly figures for one component and annual for the other
- -Confusing DCR with loan-to-value ratio or other financial metrics
Concept Deep Dive
Analysis
The Debt Coverage Ratio (DCR) is a critical financial metric used by lenders and appraisers to evaluate the ability of an income-producing property to generate sufficient cash flow 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 that the property generates more income than required to service the debt, while a ratio below 1.0 suggests insufficient income to cover debt payments. This ratio is essential in commercial real estate financing decisions and property valuation analysis.
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 all property-related loans for the entire year.
Real-World Application
Lenders use DCR to assess loan risk before approving commercial mortgages. A property with DCR below 1.20 might be rejected or require additional collateral, while properties with DCR above 1.30 are considered strong lending candidates with lower default risk.
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