Many single-family real estate investors prefer to purchase properties in the name of a limited liability company. This protects them from lawsuits and keeps their investing business apart from their personal names. For these investors, local and regional banks have historically been the best resource for refinancing loans secured by their 1 to 4-unit rental properties — that is, until recently.
A surprising consequence of the COVID-19 pandemic was an increase in real estate prices. Another surprising consequence was that the cost to borrow for investors went down. As a result, a landlord loan product commonly referred to as a DSCR loan (short for ‘debt service coverage ratio’, which is the primary factor in the product’s underwriting) has become competitive with local bank loan pricing and is taking market share away from local banks in heaps.
DSCR loans were designed with the single-family real estate investor in mind. Investors often buy in LLCs, which this product permits. Investors are often self-employed, and their tax returns are difficult to decipher — this product does not require a tax return review. For income verification, DSCR loan underwriting focuses on the rental income (in-place or potential) that the property can produce. After allocations for property taxes and insurance, the underwriter calculates a Debt Service Coverage Ratio for the property, which is a key factor in the product’s pricing. To determine value and rent, DSCR lenders require a full interior 1004 form appraisal, as well as a 1007 Single-Family Comparable Rent Schedule. The loan product is generally full recourse to the members of the LLC that own the property, and their FICO is also a key factor in the product’s pricing.
Many investors favor the DSCR loan over local bank loan alternatives due to the competitive interest rates, the simpler underwriting process, and faster relative closing time frames. It is typical for a DSCR lender to be able to pre-approve a borrower in hours and close a loan within just days after receiving the appraisal and title work.
DSCR loans can come with many features around loan terms, amortization, and prepayment penalties. The 30-yr fully amortizing DSCR loan is probably the most popular. Cash-out refinances are available, and with the increase in real estate values over the past few years, many investors are taking the opportunity to tap some of their equity and lock in rates at today’s still historically low levels.
DSCR loans have existed for years, but the rates weren’t very competitive pre-COVID and so banks reigned supreme as lenders to Main Street real estate investors. With newly competitive rates and terms designed for investors, the DSCR loan has been making a splash in the single-family investing space. And with banks struggling to ‘find their place’ in this rapidly evolving financial world, DSCR loans may be another example of the disruption that soon becomes the ‘new normal’.