DSCR Mortgages: Smart Strategy or is D for Danger?

There has been a lot of news lately about a foreclosure spike in Baltimore attributed to an investor group that purchased hundreds of single family rental properties, half of which are now in default. Check out this summary at realtor.com for more background. One of the major buzzwords coming out of this story is “DSCR” which stands for Debt Service Coverage Ratio. As a lender who offers these in all 50 states to investors, I was disappointed to see the social media comments, as usual, lacked some nuance about the loan product.

A DSCR mortgage is underwritten differently than a traditional conventional mortgage, where the lender is doing an in depth look at your overall financial profile and calculating your cash flow across all your businesses and properties. Instead, the DSCR loan looks at three things: Your credit score, Your down payment, and whether the property’s expected rent covers the mortgage payment. It’s a pretty common sense concept, really- if you have good credit and a good down payment, and the property is paying for itself, that lender thinks it’s an acceptable risk.

Sound Bite: “These loans are easy to get…they let you scale up your portfolio really quickly” - For sure, but these are still loans for investment properties. You’ll see a lot of advertising about low down payment options for this loan type, but the truth is that the interest rates at lower down payments are so high that you quickly lose the whole “debt service” part of the underwriting as the mortgage payment increases from the higher rate without any increase to the projected rent. While they do allow quick scale, they shave off a matter of months, not years.

Consider a client of mine who is currently finalizing his DSCR loan: He is an experienced real estate investor who owns a few rental properties, including a short term rental which he purchased at the beginning of this year. Unfortunately, for traditional mortgage underwriting, we couldn’t give him credit for that property’s income to offset the payment because he hasn’t filed taxes that show that income yet. When the right property showed up for his next addition as a short term vacation rental, the DSCR option was around .25% higher in interest rate but enabled him to purchase the property 5-ish months sooner than if he had waited to file taxes. Was it a great option for him where the extra months of high-season income more than offset the loan cost? Absolutely. Did it massively change his trajectory? Not so much.

So how is that debt service calculated? The lender will order an independent third party appraisal to both evaluate the value of the property as compared to sales of similar properties, but also the expected rents of the property compared to other similar rentals. Where I believe we encountered trouble here is that the comparable rent analysis methods are behind the times. Appraisers generally use the MLS for their data source, and while property sales still are overwhelmingly going to be included in that data set, most rentals in most markets are no longer going through that platform, so market data could be dated or just inaccurate if only a few rentals have reported and they were different from the market or even fraudulent.

More commonly I actually believe that the appraisal rent schedule is low compared to market rents, since the most desirable rentals won’t require the services of an agent to get rented out, but in the case of someone purchasing hundreds of vacant properties and thereby massively increasing supply without accounting for stable demand, it seems pretty straightforward that at some point rents will go down or tenants just won’t exist.

Now what was the goal here of this fraud scheme? That beats me. I am a mortgage broker, not an FBI agent, but I have a hard time believing that there was some major plan to deflate the property values of a whole city here, as suggested by the internet. I think your garden variety fraud schemes are more likely here: they pocketed the cash that was intended for the purchase price or renovations in some way and made more there than they lost in their down payment.