Debt Service Coverage Ratio Loans: Ticket to Wealth or Ruin? by Jeff Churchman

Debt Service Coverage Ration Loans: Ticket to Wealth or Ruin?

by Jeff Churchman

Debt service coverage ratio loans, which allow the borrower to qualify for the loan based on the property’s income rather than the borrower’s personal income, are not new to the world of real estate. However, their availability to small investors purchasing single family homes is a recent development and is growing. This has created opportunities previously unknown to these investors, but the loans do not come without risk, especially when obtained in the manner that many investors currently are obtaining these loans, qualifying by setting up the properties for use as short term rentals.

Leveraging financing, such as debt service coverage ratio loans, and online tools, small investors have opened up remote markets and grown substantially in recent years, accounting for fourteen percent of all single-family home sales in 2022, up from eight and a half percent in 2019. Properties that small investors may previously have not been able to acquire based on their own personal income are now within reach when underwritten based on the property’s income. That opportunity becomes even greater when short term rentals enter the picture. Short term rentals, which command higher per night income, allow investors to qualify for even larger loans than they would through traditional long-term rentals. Investors around the country are capitalizing on this increased ability to spend more for properties and building multi-million dollar short term rental portfolios in just a few years.

While underwriting a property as a short-term rental may provide for a greater ability to offer more competitive prices and thus expand a portfolio faster, it also opens the investor up to greater risk. If the investor has only qualified for the loan based on the elevated short term rental rates, trouble arises if the investor must switch the property to an alternative investment type that does not generate as much, such as a long-term rental. Investors in this situation risk finding themself in the negative on their loan because income from short term rentals is often multiple times higher than the long-term rental income from the same property. As the housing crisis in America grows, anti-short term rental sentiment is also increasing, threatening investors’ ability to continue using properties as short term rentals. Locals are blaming short term rentals for decreasing available rental units and driving the price of homes past affordable levels. Towns like Steamboat Springs are going so far as to ban short term rentals. Further, with housing markets around the country continuing to cool, those short-term rental investors who are forced to sell may find it difficult to command the price they once paid.

As investors continue to leverage debt service coverage ratio loans to expand their real estate portfolios, they would do well to remember that underwriting only for short term rentals without a backup plan creates outsized risk, putting a thumb on the scale of default. Although debt service coverage ratio loans bring great opportunity for investors, those investors must be willing to take a measured approach so as to not become over leveraged and find themselves underwater.