Navigating the complex landscape of real estate financing in California can be daunting, especially for investors seeking flexible solutions. Enter the debt service coverage ratio (DSCR) loan—a financial product tailored to meet the unique demands of property investors. DSCR loans distinguish themselves by focusing on the property’s income rather than the borrower’s personal financial history. This approach simplifies the application process and opens up opportunities for those who might not qualify for traditional lending options. Whether you’re hoping to expand your property portfolio or step into the real estate investment arena, understanding how DSCR loans work in the Golden State will provide you with a strategic advantage in a competitive market.
What is a DSCR Loan in California?
A debt service coverage ratio (DSCR) loan is a type of non-qualified mortgage loan, or non-QM loan, widely utilized in the state of California, created specifically for real estate investors who are looking to buy rental, residential, or commercial properties. Unlike conventional loans that typically require extensive documentation of personal income, DSCR loans focus on the cash flow generated by the property intended for purchase. This distinction makes them an ideal option for borrowers who may have significant real estate assets but show variable personal income on traditional financial statements.
How Does a DSCR Loan in California Work?
DSCR loans in California work by using a simple formula to determine whether the income generated by a property is sufficient to cover the loan payments. Lenders look at the property’s debt service coverage ratio, which is a measure of the cash flow available to pay the current debt obligations. To qualify for a DSCR loan, the property in question must generate enough rental income to exceed its mortgage and other related expenses by a certain margin. Typically, lenders require a DSCR ratio of at least 1.25, meaning the property’s income is 125% of its debt service obligations. This threshold can vary slightly depending on the lender’s risk tolerance and the specifics of the property market in different parts of California.
DSCR Loan California Requirements
Securing a DSCR loan in California involves meeting specific criteria set by lenders. These requirements are designed to ensure that the investment properties financed are viable and capable of generating sufficient rental income to cover their associated debts. Each lender has different requirements. Here’s a detailed look at the key requirements for obtaining a DSCR loan in California:
Minimum DSCR Ratio
The DSCR is the cornerstone of qualifying for this type of loan. In California, the typical minimum DSCR requirement is 1.25, although this can vary based on the lender’s risk assessment and the specific market conditions of the area in which the property is located.
Property Types
DSCR loans are applicable to a variety of property types, but all must be intended to generate income. This includes:
Single-family Homes
Popular among individual investors looking to rent out properties.
Multi-family Units
Buildings with multiple rentable spaces, such as duplexes or apartment complexes, which generally offer higher income and diversification of tenant risk.
Commercial Properties
Retail, office spaces, or industrial properties that are leased to businesses. These properties typically involve more significant investment and come with different management challenges compared to residential properties.
Each type of property has its own set of considerations, such as potential for income generation and associated risks, which lenders evaluate during the loan approval process.
Loan-to-Value Ratio (LTV)
The loan-to-value ratio is another critical factor in the application process for a DSCR loan. Most lenders in California offer a maximum LTV ratio of 75% to 80%. This means that borrowers must provide a down payment of at least 20% to 25% of the property’s purchase price. The LTV ratio helps lenders mitigate risk by ensuring that borrowers have significant property equity, reducing the likelihood of default.
Rental Income Verification
Lenders require documentation to verify that the projected rental income is realistic. This can be in the form of existing lease agreements showing current rental rates for the property. If the property is new or being repositioned in the market, lenders may require a market rent analysis from a certified appraiser. For example, an appraiser can supply a Single Family Comparable Rent Schedule (form 1007).
Property Appraisal
An appraisal is mandatory to determine the property’s market value and to ensure that it supports the projected income estimates. This appraisal must be conducted by a licensed professional who will assess the property’s condition, location, and comparable market transactions. The appraisal helps safeguard the lender’s investment by confirming that the property is worth the loan amount being requested.
Creditworthiness
While the focus of DSCR loans is primarily on the income-producing potential of the property rather than the borrower’s personal financial situation, lenders still consider the borrower’s creditworthiness. This includes reviewing credit scores to ensure that the borrower has a history of financial responsibility. Minimum credit score requirements can vary by lender but typically range from 620 to 680.
Cash Reserves
Lenders may also require borrowers to have cash reserves on hand. This is to ensure that they can cover mortgage payments during periods when the property may not be fully leased. The required amount of cash reserves can vary, but it often ranges from six months to a year of mortgage payments.
These requirements highlight the lender’s focus on both the property’s financial viability and the borrower’s financial responsibility. Meeting these criteria is essential for securing a DSCR loan in California, enabling investors to expand their portfolios with rental properties that have strong income-generating potential.
How to Calculate DSCR in California
Calculating the DSCR for a property in California involves a few straightforward steps:
Determine the Net Operating Income (NOI): This is the total income the property generates from rent and other fees, minus operating expenses like maintenance, management fees, taxes, and insurance.
Identify the Total Debt Service: This includes all annual payments required for the property, primarily the principal and interest payments on the mortgage.
The ratio is calculated by dividing the net operating income of the property by the total debt service. Essentially, the property needs to be able to pay for itself. A DSCR ratio of 1 or higher indicates that the property can sufficiently cover the debt obligation. Here are two examples of the DSCR in action:
Example A
A duplex in San Diego, CA, has a purchase price of $700,000. With an interest rate of 7.5%, the monthly payments would be $4,894 over a 30-year fixed mortgage. The two units in the duplex are rented for $4,000 per month, which would come out to $8,000 in total. For safety, we will estimate 1% of the purchase price for annual operating expenses, which would be $7,000.
- Annual Debt Service: $4,894 x 12 = $58,728
- Annual Operating Income: $8,000 x 12 = $96,000
- Annual Operating Expenses: $700,000 x 1% = $7,000
- Annual Net Operating Income (NOI): $96,000 – $7,000 = $89,000
- DSCR Formula:
Net Operating Income / Annual Debt Service
$89,000/ $58,728 = 1.50
With a strong DSCR of 1.50, the annual net operation income is more than adequate to cover the loan’s debt obligation.
Example B
A single-family home in Riverside, CA has a purchase price of $700,000. As before, the interest rate is 7.5%, making the monthly payments for a 30-year fixed mortgage $4,894. If the renter is charged $5,200 per month, it would bring the annual operating income to $62,400. Again, let’s estimate 1% of the purchase price to hold in reserve for annual operating expenses, which would be $7,000.
- Annual Debt Service: $4,894 x 12 = $58,728
- Annual operating income: $5,200 x 12 = $62,400
- Annual operating expenses: $700,000 x 1% = $7,000
- Annual net operating income: $62,400 – $7,000 = $55,400
- DSCR formula:
Net Operating Income / Annual Debt Service
$55,400 / $58,728 = 0.94
This example illustrates how the annual net operating income is below the threshold for covering a debt obligation adequately. Even though the $5,200 monthly income from rent is higher than the $4,894 by $306, the additional 1% ($7,000) in annual operating expenses provides a weak DSCR.
DSCR Loan California Rates
The interest rates for DSCR loans in California can be higher than those of conventional loans because they represent a higher risk to lenders. Rates can vary significantly depending on the lender, the borrower’s investment history, the type of property, and the overall economic climate.
As of now, interest rates for DSCR loans in California typically range from about 7% to 8%.
DSCR loans offer a compelling financing option for real estate investors in California. By focusing on the income potential of the property rather than the borrower’s personal financial history, these loans simplify the investment process and can facilitate rapid property acquisition and portfolio growth. For any investor looking to expand or start their real estate ventures in California, understanding and leveraging DSCR loans can be an essential part of their strategy.
Discover DSCR Loans in California with Independent Lending
Having facilitated over $500 million in mortgage lending since 2013, Independent Lending is California’s premier lender for DSCR loans. Our team of experts makes it easy to get an upfront approval for a new DSCR loan. For California applicants, there is no strenuous mortgage application process like a traditional lending program. Independent Lending proudly holds an A+ rating with the BBB and has received several 5-star reviews on Zillow and Google. With more than forty years of combined experience in mortgage lending, California applicants can count on transparency, clear communication, and quick service throughout the whole lending process. If you’d like to learn more about our flexible DSCR loans, contact us today!
