This article was originally published July 17, 2023 on BiggerPockets
DSCR loans, while still a relatively new product, continue to expand in use and popularity for investors looking to achieve financial freedom through real estate. Throughout 2023, we have published several articles on DSCR loans, introducing the BiggerPockets community to how interest rates and terms are determined, giving answers to frequently asked questions about DSCR loans and talking about exciting new developments and expansions of the product, including DSCR loans for five- to 10-unit multifamily properties.
This article will cover another big aspect of DSCR loans–specifically, what documents you will be expected to provide once you have decided to go with a DSCR loan.
One of the most enticing aspects of DSCR loans for investors is the lower documentation, paperwork, and overall “hassle” when compared to more traditional lending, including conventional and bank options. However, DSCR Loans should not be considered “no doc” loans–they do include a well-thought-out underwriting process and meaningful “common-sense” documentation requirements as well. Sometimes people can be misinformed, thinking these are loosely originated mortgage loans akin to the “NINJA” (no income, no job, and no assets) loans that were common in the early 2000s and helped lead to the last real estate crash.
After reading this guide, you should be both well-equipped to know what to expect in the DSCR loan underwriting process and be able to dispel any myths about DSCR loans being a repeat of the poorly documented “no doc” loans of the past.
What are DSCR Loans?
While there isn’t an exact, commonly agreed-upon definition out there, here is a handy definition for this specific loan product:
DSCR loans are mortgage loans secured by residential real estate turnkey properties, strictly used for a business purpose and underwritten primarily based on the property.
Important note: DSCR loans refer to the specific loan type, and the “DSCR ratio” (debt service coverage ratio) is a metric used for underwriting and evaluating these loans (and other loans), but the metric and ratio itself are distinct things versus what is referred to as “DSCR loans.”
Some key things to note in the definition:
- DSCR loans are secured loans (meaning that there is collateral that the lender can take if the borrower doesn’t pay back the debt). They are also mortgage loans, i.e., secured loans for which the secured collateral is real estate.
- DSCR loans cover residential real estate properties, not commercial real estate properties. So investment properties that are commercial in nature (think office buildings, retail strip centers, etc.) cannot use DSCR loans. They can be leveraged with commercial real estate loans that use the DSCR metric for evaluation; however, these are not under the “DSCR loan” product bucket.
- DSCR loans are for “business purpose,” only meaning that the owner of the property can not live in the property under any circumstances. These loans are strictly for investment properties where the property is owned and operated for business purpose and rented out for income. Additionally, for DSCR loans for which the purpose is a “cash-out refinance,” the use of the cash-out proceeds must also be used for a business purpose. Commonly, these proceeds are used for further real estate investment or costs related to the borrower’s real estate business and strictly can‘t be used for personal uses, such as paying off personal credit cards or any nonbusiness expense.
- DSCR loans are “primarily based on the property,” meaning that the lender evaluates and qualifies the deal mostly but not completely based on the property’s investment potential. This is a common misconception where people sometimes assume DSCR loans are purely based on the asset. DSCR lenders will run personal credit (which, along with LTV and DSCR, is among the three biggest factors determining your rate and terms) and typically require three to six months of PITIA “reserves” in liquid assets. The rest of the documentation and underwriting will be based on the asset, but it’s important to remember that qualification isn’t 100% based on the property. Your credit and some basic liquid assets matter, too.
- Finally, DSCR loans are for “turnkey” properties only, meaning any property needing any significant renovations or rehab is not going to qualify, and you will likely need to explore hard money options instead.
DSCR Loans—Not “No Doc” and Not “NINJA”
One of the commonly agreed-upon drivers of the 2008 real estate crash was loans with poor underwriting standards to unqualified borrowers. It was common to see inexperienced borrowers qualify for and amass many loans with almost no money down and exotic loan structures. Further, many qualification standards were low, not requiring proof of income or much in the way of evaluating whether the borrower was going to be able to pay the loan back.
Because of this, sometimes people hear about DSCR loans, which are best known for being based primarily on the asset and not requiring or evaluating W2 income or DTI, and associate them with the poorly constructed loans of the past.
As the rest of this article will demonstrate, this is misleading, as DSCR lenders will require common-sense documents to properly underwrite a file and evaluate and limit risk. Further, DSCR loans are much more conservative, for example, generally limiting LTVs to no more than 80%, requiring strict rules around third-party appraisals for valuations, and conservatively evaluating how each property will perform as a rental.
Additionally, DSCR loans generally have none of the confusing and exotic loan structures of the past, where borrowers were faced with quick and potentially rapid increases in interest rates. Almost all DSCR loans are fixed-rate, 30-year mortgages, and the ones that aren’t typically fixed for at least five years and have built-in limits against rates increasing too much and too quickly.
DSCR Loan Documentation Requirements
The following is a brief checklist of the documents that you will be expected to provide when going through the process of obtaining a DSCR loan. It is important to remember that DSCR lenders are all following the 100% exact same guidelines and requirements, such as conventional lenders originating Fannie Mae-qualified loans.
DSCR lenders typically have mostly the same guidelines, but each are a private lender and has differences. Additionally, not all DSCR loans will have the exact same document requirements based on the deal itself and won’t be applicable. Some examples of this are “entity” documents, which are only required if the loan is taken in the name of an entity, like an LLC.
The DSCR Loan process typically starts with the application. Some DSCR lenders will use the standard Fannie Mae Form 1003 application. However, this is designed for conventional loans (including normal owner-occupied loans) and includes lots of questions and information not required by DSCR lenders.
Several DSCR lenders, especially ones focused solely on DSCR loans and financing real estate investors, will have customized applications that have questions and fields only specifically needed for DSCR loan qualification. These custom-built applications are typically a few pages and take approximately 15 minutes to complete.
Typical items included are questions about the property, real estate investing experience, financial profile, the entity (if borrowing through an LLC), and optional demographic information.
While all of this information will be checked and verified during the underwriting process, and rough estimates are generally OK, it is very important to be truthful on the application. As a DSCR lender finding evidence of misstatements on the application later in the process can have serious consequences.
This document authorizes the DSCR lender to pull a credit report for the guarantors on the loan. Note that mortgage lenders use a slightly different credit report with a focus on other real estate debt history than others, so your score with a DSCR lender may be slightly different from what you would find in other places.
Generally, DSCR lenders will require two months of bank statements to prove minimal liquid asset “reserves,” generally in the amount of three to six months of PITIA payments. While these loans must be used for business purposes, it is perfectly fine and acceptable for the individual borrower to pay debt service from personal funds if needed. This can occur if the property experiences vacancy or turnover or maybe is a short-term rental in a seasonal market, and some months bring in light amounts. The liquid asset reserves provide a “cushion” for these cases.
Most DSCR lenders will also allow for retirement accounts or stock and bond portfolios to satisfy this requirement, often with a 20% or so “haircut” of the amount to account for the lower liquidity and value risk.
DSCR lenders will require that the property is properly insured against potential damage and destruction, typically at a minimum of the loan amount or replacement cost. This ensures that if the property is destroyed, the DSCR lender can recover the funds from the loan in a payout of no less than the principal balance. Flood insurance to this amount is also required if the property lies in a federally designated flood zone.
If the property is leased as a long-term rental, copies of the leases are required to be provided, and they must be in proper order (clearly signed with rents and terms fully clarified). One thing to watch out for is when purchasing a property that is currently leased out: things typically run the smoothest when the seller can provide these leases quickly.
Short-term rental history
If the property has been utilized as a short-term rental, the last 12 months of bookings and receipts are typically required by the DSCR lender. Usually, these can be downloaded and sent fairly easily from short-term rental platforms such as Airbnb and VRBO.
These are not applicable if you are borrowing as an individual but are required if, like many investors, you choose to set up an LLC. For borrowers who go this route, a few documents are typically required. It will often depend on the state of incorporation.
Typical entity documents required by DSCR lenders include:
- Certificates of Good Standing
- Certificate of Formation
- Articles of Organization
- Operating Agreement
For borrowers who follow the BRRRR method and use DSCR loans for a quick cash-out refinance, documentation of all the renovation work is often required. These will typically include receipts, invoices, and work orders from the rehab work on the property.
While there are a few more documents that go into the loan file, these are obtained by the DSCR lender and don’t have to be provided by the borrower. These include an appraisal, appraisal review, and title insurance.
Overall, DSCR loans are a great product because the documentation requirements are limited and reasonable, ensuring solid underwriting and protecting against risk and market meltdown while not being a hassle and nightmare of paperwork.
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