Transcription
Everyone's trying to get debt service coverage ratio loans like they're the golden ticket to building a rental portfolio. But there is a massive problem almost no one is talking about. One that is all but guaranteed to trigger a wave of defaults. And it's hiding in plain sight, buried in the way these loans are approved. Once you see it, you won't be able to unsee it. Let me explain.
The whole issue starts with how these loans get approved. The debt service coverage ratio that these lenders use is not the same as what traditional commercial lenders have used for decades. This new DSCR formula doesn't account for any expenses other than the PITIA. That's principal, interest, taxes, insurance, and association dues, if any. So, what does that mean exactly? It means that the lender takes the property's gross rent, adds up the PITIA costs, then divides the gross rent by the PITIA to get the DSCR. I know that's a mouthful and a lot of acronyms. Don't worry, I'll break it all down in a moment. The main point is that if the resulting number of this calculation hits the lender's minimum threshold, typically 1.0 to 1.25, the loan gets approved. If it doesn't, it gets denied. That's it.
On the surface, this all looks simple, but let's run through an example, and I'll show you why this math is dangerously misleading. Let's say the monthly rental income on a property is $2,000. The monthly costs are principal $100, interest $1,200, taxes $500, insurance $100, and there are no homeowner association fees. Total PITIA is $1,900. Now take the $2,000 in gross rent and divide it by the $1,900 of PITIA. This is the typical DSCR lender's formula for determining whether the loan qualifies for financing or not. The resulting debt service coverage ratio in this example is 1.05. If this lender's minimum ratio is 1.0, this property qualifies. If the borrower has decent credit and a solid down payment, the lender is ready to go. No income check, no W-2s, no tax returns, no review of the borrower's existing portfolio. The lender might ask for 20 to 25% down and require some reserves in escrow, but other than that, you're good. If you don't yet see the problem with this qualification criteria, keep watching.
And here's the wild part. These lenders openly admit that they don't consider any of the other actual expenses you will face as a landlord. It doesn't matter to them. They just don't care. Case in point, Christian Bachelor, a mortgage broker who partners with David Green, formerly of Bigger Pockets, said this casually on the Bigger Pockets podcast a year and a half ago. "Let's start off by just describing what does DSCR stand for and how is it different than conventional underwriting. DSCR, to answer your question, David, stands for debt service coverage ratio. It's a bunch of fancy words that don't mean anything unless you understand it. All that means a ratio is obviously a ratio of two numbers and that's going to be your rents over your debts. It's an easy way to think about it, right? So if you have a property that rents for $1,000 a month and your mortgage is $750 a month, you have a cash flow positive property, right? And that mortgage has to include your PITI. Now a lot of people may ask, what about the utilities? What about the, you know, maintenance? What about capex? All those other things. Bigger Pockets told me that's all well and good. You should put that in your calculators, but it is not how they calculate the ratio that qualifies you for the loan. All they care about is your gross rents over your gross liabilities, including principal, interest, taxes, and insurance."
The wildest part, this was said on the podcast that spent years preaching responsible rental analysis. Just think about it. A DSCR lender's entire business model is supposed to be based on rental income covering expenses, but they completely ignore half of the actual expenses. It's absolutely insane. Just ludicrous. And this wasn't just one guy. Christian said he works with over 75 DSCR lenders and they all use the same formula. And in my own research, I saw the same thing over and over again.
So, let's stress test that qualified loan from earlier and see what's really going on. Let's say we're buying a two-family rental for $225,000. We put 20% down, which gives us a $180,000 loan. We get a 30-year amortization at 8% interest. Gross monthly rent, $2,000. PITIA, $1,900. So, in the lender's eyes, this property cash flows at $100 per month. But in reality, this property is 100% without a doubt guaranteed to be cash flow negative and not by a little. Let's break it down. Here are just a few of the expenses not accounted for by the lender. Vacancy, 5% of gross rent, equals $100 per month. Repairs and maintenance, 10% of gross rent equals $200 per month. Capital expenditures, 5% of gross rent equals $100 per month. Water, sewer, garbage. Usually a fixed expense that can't be passed on to a tenant in a small multi-family property like one in our example, $200 per month. Utilities, which might include gas and electric for common areas, laundry, and maybe heating if there's just one boiler supplying heat for both units, $150 per month. Total additional expenses, $750 per month. Now, subtract that from the supposed $100 of so-called cash flow, and this property is actually losing $650 per month, negative, every single month. That's $7,800 per year. And yet, this loan gets approved.
Now, you might say, "Okay, but most lenders use a higher DSCR qualifier." Okay, what if the lender required a 1.2 debt service coverage ratio? You might say that is more common and much more conservative. Most lenders would probably have that as their ratio rather than something like 1.0. Cool. Let's run that. Same property, but now rent is $2,280 per month to meet the 1.2 DSCR. PITIA is still $1,900. $2,280 minus $1,900, you get $380. So $380 per month is the quote unquote cash flow according to the lender, but your unaccounted for expenses are still $750 per month. So now you're losing $370 per month or just $4,440 per year. Again, approved. And again, the borrower is bleeding cash every single month just to keep this thing afloat.
Now maybe you say this example is still too extreme. Fine. But even if the shortfall is just $100 per month, that is still a huge problem. Because here's the question. If the lender isn't checking the borrower's income, how do they know the borrower can afford any out-of-pocket losses? What if this borrower bought 10 properties just like this one, all slightly cash flow negative? What if his day job barely covers his own mortgage and groceries? The lender wouldn't know that because they don't ask during this approval process. Now, think about this logically. If that borrower had to choose between paying his failing rentals or paying for groceries and his own home, which do you think he would pick?
And here's the scariest part. Most new investors don't know how to run these numbers properly. They don't realize they're buying a money pit instead of a cash flowing asset. Since DSCR loans exploded in popularity a few years ago, hundreds of fly-by-night lenders have popped up, and they've all been in a race to the bottom, offering easier terms, fewer checks, and billions in issued loans to underqualified buyers secured by underqualified properties. And it's not just the underwriting that's dangerous. DSCR loans often come with higher interest rates, typically 1 to 2% more than the comparable conventional loans. Combine that with inflated purchase prices and you've got a perfect storm brewing in the rental market.
So, how are these lenders still in business? Surely they know these loans are not sustainable, right? They do. They just don't care because they're not the ones holding the bag. Most DSCR lenders sell their loans immediately on the secondary market. They package them up and offload them to hedge funds and other financial institutions. Does this sound familiar? That's not stupidity. That's fraud. Meanwhile, the lenders rake in the fees, points on the loan, origination fees, volume bonuses. They're making money either way. And I'm sure the thinking is, hey, as long as values go up, borrowers can always refinance or sell before things get bad. But this is a dangerous game of musical chairs. And when the music stops, it won't be these DSCR lenders left standing without a seat.
Now, don't get me wrong, DSCR loans can be useful for the right investor. They let you buy rental properties with fixed interest rates, 30-year amortization, no personal income verification, no limit on number of loans, and title in an LLC, which conventional loans do not allow. Use wisely. These are powerful tools, but you have to know your numbers, not the lender's version, the real numbers. If your deal has a strong cash flow cushion after all expenses, then yes, your personal income doesn't matter, and the DSCR loan becomes a tool for scale. But if you're relying on the lender's math to tell you whether a deal is good, you're walking straight into a trap. Don't be that investor. Do your homework, run your numbers, and don't trust the lender shortcuts. And if you want to learn how commercial lenders calculate DSCR the right way, check out this video I recently posted on this channel. Tap or click the screen and I'll see you there.