Buyers of income property usually think price is set by what they are willing to pay. On anything financed, it is more often set by what the lender will advance — and that is driven by a single ratio.
The ratio
Debt service coverage ratio is net operating income divided by annual debt service. A building with $120,000 of NOI and $100,000 of annual principal and interest has a DSCR of 1.20.
Lenders set a minimum. Whatever loan amount produces that minimum at the lender’s qualifying rate and amortisation is the loan you get — regardless of the loan-to-value you were hoping for.
Why this caps the price
Work it backwards. Your equity is fixed. The maximum loan is fixed by the DSCR test. Price is the sum of the two. So if NOI comes in lower than the seller’s presentation, the maximum loan falls, and the price you can pay falls with it — often by more than the NOI shortfall would suggest, because the effect is leveraged.
This is why arguments about management fees and capital reserves in the NOI are not academic. Each dollar removed from NOI removes several dollars of borrowing capacity.
The qualifying rate, not the contract rate
Lenders normally test coverage at a rate above the actual contract rate, and at a stated amortisation. Ask your lender what both are before you write, and run your own numbers at those figures rather than at the rate you were quoted. Buyers who underwrite at the contract rate get an unpleasant surprise at approval.
The five-unit line
In Canada, one to four units is generally financed as residential property against the borrower’s own income and credit. Five units and above is commercial multi-family lending, underwritten primarily against the property. That is where CMHC-insured financing becomes available, typically offering longer amortisation and better pricing — at the cost of a longer approval timeline, because the insurer underwrites the asset as well as the borrower.
Crossing that line changes almost everything about how a purchase is structured. Know which side of it you are on before you start shopping.
What improves coverage
- Real NOI growth. Bringing below-market rents to market, lawfully and with proper notice, is the most direct lever.
- Expense discipline. Every dollar of recurring operating cost removed is a dollar of NOI, and several dollars of borrowing capacity.
- Longer amortisation. Reduces annual debt service and improves coverage, at the cost of more total interest.
- More equity. The blunt instrument, and sometimes the right one.
Underwrite it before you write
Build your own model from the leases and the financial statements, apply a market management fee and a capital reserve, use a market vacancy allowance, then run the coverage test at your lender’s qualifying rate. Do it before the offer, not during conditions. A financing condition is a safety net, not a substitute for arithmetic.
This article is general information, not financial or investment advice. Speak to your lender and your accountant about your own situation.
Talk it through with Rimrock
Rimrock Sales & Leasing works with owners, investors and tenants across Calgary, Edmonton and Lethbridge. Get in touch or call 403-910-4611.