Platforms like Airbnb, Booking.com, and Vrbo have simplified the process of starting a short-term rental business. One of the hurdles, though, that remains is financing your new investment property. As it won’t be your primary residence, applying for conventional loans will most likely not deliver a successful outcome.
Enter DSCR loans. It’s been designed specifically for rental properties and plays a key role in commercial real estate transactions. Here’s a summary of what you need to know about the DSCR loan program.
The DSCR in DSCR loan stands for debt service coverage ratio. In a nutshell, it refers to the ratio of a property’s net operating income to its debts and other expenses.
DSCR lenders use this ratio to determine if you’re eligible for this loan. This number gives them a way to determine your ability to pay your mortgage payments using the cash flow that your rental property is expected to bring in.
Conventional loans use criteria like your personal income and employment history. This means that mortgage companies that offer this type of option are more strict when it comes to awarding loans, making it difficult for “unconventional” careers like running a short-term rental business.
Instead of using your pay slips (which you’ll most likely not have when you’re renting out an Airbnb property), DSCR lenders will consider the monthly rental income potential of the property. As they rely on cash flow generated via a rental activity instead of your income, you can’t use it to buy a primary residence.
Here are two of the main reasons why real estate investors can prefer the DSCR loan program over other loan options:
As you’ll be using the rental income potential of the real estate investment, this option makes it a great choice if you want to give up your day job and become a full-time real estate investor.
This also makes the whole process — application as well as closing — faster. Basically, the only thing that needs to be verified is the debt service coverage ratio of the investment property you’re interested in buying.
For those interested in growing their real estate investment portfolio to multiple properties, this route can make the most sense. It allows you to acquire your next investment property before you’ve paid off your current loan.
Aside from being able to invest in multiple properties, you can also use it to finance various types of properties. Considering that travelers are keen to explore unique stays, this is a bonus.
While DSCR loans can help you to buy a rental property which would otherwise not have been possible, there are drawbacks to consider. These include:
Compared to conventional loans, you’ll usually need to have a bigger down payment ready to get approved for a DSCR loan. Your credit score will impact the percentage required and you can end up having to put down anything between 20% and 30%.
The reason for this is that these types of loans are linked to more risk. As you won’t need to show proof of a fixed monthly salary, DSCR lenders will be concerned about your ability to pay the monthly payment during the slow season when your vacation rentals generally get fewer bookings.
While you won’t have to show proof of personal income, there’s a possibility that they’ll ask about your cash reserves. Most lenders will want to know that you’ll be able to continue to make your monthly payments even when you experience a drop in bookings.
To work out your debt service coverage ratio, the DSCR lender will divide the property’s potential gross rental income by the principal debt service along with the interest.
The answer should be at least 1.0. With this ratio, you’ll be able to afford the monthly mortgage payments.
That being said, it won’t leave you with enough to cover other expenses involved in running a short-term rental business like marketing, accounting fees, and cleaning supplies. As such, your ratio should ideally be a minimum of 1.25 and many lenders’ minimum requirements will be set at 1.2.
Other popular loan options that real estate investors can explore are hard money loans and cash out refinance loans. Like with DSCR loans, each of these also has its own unique pros and cons. Here’s a quick look at these two loan options:
A hard money loan is a type of short-term loan that’s awarded by a private lender for investment properties. Similarly to a DSCR loan, the approval process is relatively fast and it can also be used for less traditional property types.
While your credit score will have less of an impact on the outcome, get ready to pay higher interest rates and a bigger down payment. You’ll also need to be able to repay the short-term rental loan in a much shorter period.
If you already own a property, you might be able to apply for a cash-out refinance loan. That said, these loans aren’t that commonly available and might come with Ts and Cs that require you to stay at the property for a period.
Similarly to DSCR loans, you’ll be able to use your rental income to refinance your new loan application. Basically, you’ll be replacing an existing mortgage with a new loan. You can also use it to pay for renovations.
Whichever type of Airbnb financing you end up applying for, it’s crucial that you put in place a system to stay on top of your finances going forward. A DSCR loan might not require you to show detailed records of your personal income, but you’ll want to ensure that your property’s cash flow can meet the loan payments. Then, you’ll also need to ensure that you can maintain a positive cash flow so that you can cover your ongoing expenses.
To help keep track of your financial flow, you can check out a tool like iGMS, for example. Included in its long list of features are payout reports. You can use this report to get a quick overview of how much you’ve earned in total. Then, using specific filters, you can also get a more detailed view of your income data. In addition to tracking your property’s income, it’s also useful for monitoring cleaning fees and Airbnb’s service fees. Plus, it also shares data about future transactions, giving you insight into your expected rental income.
If you’re serious about acquiring more Airbnb properties, a tool like iGMS will come in handy. It has helped several companies to expand the number of listings they manage. For example, Innovation Style managed to grow from 10 Airbnb listings to over 40 after partnering with iGMS.
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