There are few numbers more important in commercial real estate than the debt service coverage ratio.
It’s one of the first things and one of the last things that any commercial lender or broker will talk about. It’s first and last because it’s simply that important!
A lot of people toss this term around without explaining it while others are using it without fully understanding it. It’s a lot more than just a simple formula and when you understand the debt coverage ratio, you’ll be able to control it to get maximum financing.
Let’s dive into it.
Why the DSCR is Important
Imagine finding a commercial property worth $400,000 and you need to put 25% down.
You think, “alright, I can afford that!” and move forward with the deal, expecting $300,000 in loan proceeds.
As you approach closing, your mortgage lender calls you to say “The maximum loan we can give you is $225,000 because the debt coverage ratio is too low.”
Now what do you do?
This is real and happens every day. To avoid a situation like this, you need to fully understand the debt service coverage ratio before you make offers.
The fact is that it’s regularly used by banks and loan officers to determine if a loan should be made and what the maximum loan should be. If you don’t have the extra money laying around, you won’t be able to close the deal and you’ll lose a lot of money.
Debt Service Coverage Ratio Defined
The debt coverage ratio is a simple ratio that tells a lender how much of your cash flow is use to cover the mortgage payment. It’s known as the debt service coverage ratio, debt coverage ratio, DSCR, or DCR.
Debt Service Coverage Ratio Calculation
In general, it’s calculated as:
Net Operating Income = Gross Income – Total Operating Costs
Debt Service = Principal + Interest
To calculate the debt coverage ratio of a property, first, you need to calculate the NOI. To do this, take the total income, subtract any vacancy, and also deduct all operating costs.
Remember, operating costs do not include debt service (principal and interest), or capital expenditures. Insurance and taxes are operating costs, so don’t forget to include them.
Next, take the Net Operating Income and divide it by the annual debt service, which is the sum of all principal and interest payments during the year.
To do this you must take the entity’s total income and deduct any vacancy amounts and all operating expenses. Then take the net operating income and divide it by the property’s annual debt service, which is the total amount of all interest and principal paid on all of the property’s loans throughout the year.
How The Debt Ratio is Used
A Debt Coverage Ratio below 1 means the property does not generate enough revenue to cover the debt service while a debt ratio over 1 means the property should, in theory, generate enough revenue to pay all debts.
It’s very common for lenders to require a 1.2 DSCR, give or take.
If your debt coverage ratio is too low, the only way to make it work out better is to reduce the loan balance. Your NOI is the same but now your principal an interest decreases, making the ratio go up.
And that’s how you can get your loan proceeds cut dramatically.
Debt Coverage Ratio Example
Let’s say there is a property that generates $10,000 in revenue, has total operating costs of $4,800, and yearly debt service of $4,000
NOI = $10,000 – $4,800 = $5,200
In this example, the debt coverage ratio is above 1.2, so this would be a good risk for the bank and they’d likely give the loan.
Let’s say that interest rates change and the bank gives a slightly higher rate, causing a new debt service of $4,500.
Notice how a small change can suddenly change everything!
The Bank Will Reduce Your Loan
In this situation, the bank probably won’t reject the loan. Instead, they will reduce the loan balance until the payment comes in line with their minimum DSCR requirements.
In this situation, the lender will simply reverse the formula and determine what the maximum debt service can be. We can plug in the variables we know to solve for the allowable debt service
1.2 = $5,200 / Max Debt Service
Max Debt Service = $5,200 / 1.2
So, the maximum debt service can be $4,333. Now they just need to figure out what loan balance that will be based on their interest rate and loan term.
…and you’ll be stuck trying to squeeze some quarters out of your couch to pay for the extra down payment.
How the Debt Ratio Affects Returns
In the example above I showed how a loan can be adjusted down before the lender will give the loan. This can significantly reduce your cash on cash returns.
Let’s say you are buying a property in the example above costs $100,000 and requires a down payment of $25,000.
Let’s also say that it generates $10,000 in cash each year and has an NOI of $5,200.
Originally the debt service was supposed to be $4,000 per year, leaving $1,200 in total cash flow.
Now, let’s calculate our cash on cash return. We know that it’s calculated as:
Cash on Cash Return = Total Cash Flow / Total Cash Invested
CoC = $1,200 / $25,000 = 4.8%
This means that for every $100 you invested, you get back $4.8 every year, cash in the bank. This is not to be confused with the overall return on investment.
But due to some fluke, the terms changed and now the debt service will increase. Let’s say that the interest rates increase so your $75,000 loan is at 4.5% now and your debt service goes up from $4,000 per year to roughly $4,560/year. You can see that the new debt service coverage ratio is well below the 1.2 minimum.
I’ll spare you the math, but when I punch it into a calculator I find that the maximum loan value is now roughly $71,000. This creates a yearly debt service of $4,320, bringing you back to 1.2
Comparing The Two Scenarios
Since you’re loan has gone down, you will need to invest an extra $4,000. You’ll also have a lower cash flow because of the higher debt service.
Cash Flow = $5,200 – $4,320 = 880.
Now let’s compare two scenarios. Imagine if you were still able to get 25% down, your cash on cash would look like:
CoC = $880 / $25,000 = 3.5%
Not very good, right? But, that’s because of the increased interest rates.
Now, let’s see how the change in the loan amount affects your return. Remember, your down payment is no longer $25k because it became $29k.
CoC = $880 / $29,000 = 3.03%
Never Neglect the Debt Coverage Ratio
You can see how important this simple ratio is to banks. It can change your returns, your down payment requirements, and it can even kill your deal.
Cap Rate, Explained
Whenever you’re pitching, shopping, brokering or hunting deals, one of the first terms you’ll come across is the “cap rate.”
Short for capitalization rate, at its most basic form, the cap rate indicates the annual yield on a real estate property.
But that’s not all it’s good for. It can also indicate valuations, feasibility of a deal, and what you should pay for a property. Here’s WealthLAB’s Cap Rate, Explained.
What is a cap rate?
The basic formula of the cap rate is the property’s net operating income (NOI) divided by the purchase price. It basically means the yield (return) of the property without considering debt or anything else. Or, in layman’s terms, it lets you know (an estimate of) your cash flow in advance.
Cap Rate Example
Let’s take a 20-unit property in Atlanta listed for $2 million. The rent roll for the year comes out to $300,000 with operating expenses totaling $100,000.
$200k divided by $2M = 10% = a 10% cap rate. (In everyday lingo, you’ll hear people call that a “10 cap.”)
How can I use it?
Quite a few ways. The most basic one is to compare the cap rate of a property you’re considering investing in vs. the average cap rate for the market. This would let you know whether you’re getting a good deal or not.
You can also use it when projecting income against a property you plan to upgrade. Then it would be a “pro forma cap rate.”
Find your price
You can also use it to find the price you’re willing to pay. But perhaps your strategy says you’ll only buy properties at a 12% cap rate. So now you can use the cap rate to calculate what your offer should be.
Using example above, if NOI is $200k, simply divide by your desired cap rate offer price (12%) = $1.66M = your offer price.
What’s a good cap rate?
It all depends, really.
Depends on the market, the state of the property, the cost of capital. In so-called gateway markets (think New York City, London, Tokyo etc.), the cap rates are lower because of the idea that — just like bonds and other “safe” instruments — investing in big markets is a safe play.
In addition, properties in big markets traditionally trend upwards—thus offsetting the lower cash flow.
In smaller markets, where there are less job, less people, and therefore less rental demand, the value doesn’t trend upwards as much; they remain stagnant.
For that reason, they’re deemed more risky and you’d seek a higher cap rate to get higher cash flow to mitigate that risk.
Yes, cap rates are also used to value properties. Again, going by the average cap rates for a given market, once you recapitalize (refinance), the lender—vs. the free market—will set a value of your property.
So the value would be found like this: NOI divided by cap rate. Let’s use the Atlanta 20-unit as an example. That particular type of property in that particular market has an average cap rate of 8%.
$200k NOI divided by 8% = $2.5M = your property’s value.
Is The 1% Rule Garbage?
There’s a lot of “rules of thumb” floating around out there related to real estate. The one I hate the most is the 1% rule.
It’s wrong. It doesn’t work. Period.
Let me explain…
The 1% Rule Explained
Let me take a step back and explain the 1% rule first.
In a nutshell, it says that the monthly rent for your rental property should be at least 1% of the property value. If you can meet this goal then you can make some good money in real estate.
So, if you find a property that rents for $1,000/month and you can negotiate a price of $100,000 then you’re in good shape.
…at least according to the people pushing the 1% rule.
Breaking Down the 1% Rule
Let’s say that that you find a property that is $100,000 and rents for $1,000.
We know around 5-10% goes straight to vacancy. So, that leaves you $900.
And 50% of that goes to expenses. Leaving you with $450.
And a 30 year mortgage on an $80,000 loan (I assume 20% was put down) is around $429.
So, that leaves you around $20 – $70 (depending on vacancy) each month.
…not very sexy is it?
The Break Even Ratio
Traditionally, the 1% rule was considered the break even rule. Where you would most likely cover your debt when rents are 1% of your purchase price.
So, what happened?
I don’t know for a fact, but I think a couple of things happened.
Turnkey Real Estate Companies
First, I think that turnkey companies started pushing it as a solution. A turnkey company finds a distressed property, rehabs it, puts a tenant in there and sells it to you for at or above market price.
There is definitely some value to what turnkey companies do, but often they based their prices on the 1% rule and not necessarily on market value. That allows them to get higher prices in generally low cost markets.
They justify it with free education. They teach you that if you can get 1% of the value as rent, then the deal is great and you can make a ton of money…
To people on the west coast or other high-cost areas, this seems awesome because the ratios there are closer to 0.5%. So, relatively speaking, they are “great deals” even though they are overpaying.
There are a ton of new gurus out there pushing all kinds of different ideas. Some are good and some are not, but the 1% rule keeps popping up, especially with online education.
Often, these are run by people who own a few properties and have done really well since the recession. It makes sense if you think about it. If you bought at 1% back then and rents and prices have almost doubled, then you are way above 1% based on what you purchased it for.
But, that is buying based on speculation that the market will improve, not based on the fundamentals of the deal.
Another common guru you see out there now is someone who’s only been investing for a few years. Even if they are doing great but they haven’t really been around long enough to see and understand the nuances.
They don’t realize that the 1% rule works when there are massive rent growth and appreciation but could never work in a sideways or downward trending market.
What About Using it As a Filter?
People will suggest using the 1% rule as a filter to go through hundreds of deals quickly. Here’s how they suggest you do it:
list all the prices, list all the rents, then calculate the ratios. Anything under 1% toss out and anything over 1% keep and look at deeper. So, a spreadsheet might look like this.
Based on this, you should consider buying the first, third, and fifth property on the list because the ratios are all above 1%.
But, this is missing a HUGE amount of detail. What is most important is not what it’s receiving for rent today, but what it could be receiving after you own it. So, you should based your numbers on potential rent not current rents.
Based on the new spreadsheet, the best potential deals are the 4th and 6th. While others may have potential as well based on the 1% rule, you see some really good ratios on deals you would have previously discarded.
That’s why the 1% rule is kind of silly. It leads you to discard potentially great deals in favor of more marginal deals.
Focus on The Numbers
The rent to price ratio is an important ratio to consider before purchasing anything. Just remember, it is a rule of thumb. Also, remember what it truly means:
The 1% rule is the break even rule not a rule to earn you money.
Rules of thumb are designed as a reality check. Things like the 50% rule to expenses or the 1% rule are there to act as a guide. If you are running the numbers and you’re rent is 1.5% while everyone else is at .75%, then you should think twice.
Or, perhaps your expenses are at 25% and everyone else is running at 50%. Then you should double check.
They are not and should never be used to make a buying decision.
That’s why I give away simple calculators like this one, to point you in the right direction.
The No. 1 Strategy To Build A Rental Property Empire
It’s impossible to buy enough rental property to retire with, right? It simply takes too long to save up, buy property, and a little rent over years
You just need too much money for down payments to keep buying.
It’s true that buying rental property is a very capital intensive process and it’s true that you generally need 20-25% down for your purchases (except your first few which can go FHA or VA).
It’s also true that most people don’t have unlimited funds and can’t keep putting 20-25% down.
But here’s the thing – you don’t have to keep putting money down.
There’s this really simply strategy that allows you to avoid doing all that. You guessed it, it’s called the BRRR strategy and I’m going to go into that in a lot of detail. But first…
A quick story about how I retired using the BRRR real estate method.
BRRR Strategy During the Great Recession
A long time ago I started using the BRRR strategy before anyone ever called it the BRRR strategy.
In a nutshell, it’s a way to buy property that allows you to preserve capital in order to buy more and more properties over time.
I’m going to get into detail on it in a minute, but I want to take you back to 2009 through 2013 during the deepest part of the great recession.
No one had jobs. No one could afford to pay rent. Housing prices dropped like a rock and flat lined like a hospital patient. There was no bounce.
It was just despair everywhere.
They call it the great recession, but in historical terms, it was clearly a depression.
…and I decided to get into real estate.
Everyone said I was crazy, and I was a little crazy. A lot of people had just lost everything, tenants weren’t paying, evictions were happening all over. It was rough.
But, deals could be found everywhere. The other benefit was since no one had work contractors were easy to find and would work for 1/3 what they charge now.
The hard part was finding money to invest and finding banks to lend.
I bought my first 3 family in 2009, then bought a 4 family a few years later in early 2012. This is a picture of the 4 family, sexy isn’t it?
By 2015 I had over 20 units. By 2017 I had around 35, and now in 2018 I’ve moved up to apartment complexes and have over 470.
This is the strategy I used to keep buying more property while continuously putting more money in my pocket.
Here’s how brrr investing works in real estate.
Using the BRRR Strategy to Build a Rental Property Portfolio
The overall Gist of the BRRR method is to add enough value to a property that when you refinance it you will get most, if not all of your capital back. This allows you to take your money and use it over and over again to buy deals.
Just in case you aren’t yet aware, BRRR stands for Buy, Rehab, Rent, Refinance. Alternatively, some people call it the BRRRR method which stands for the exact same thing, except the last R stands for “repeat.”
So, BRRRR method is Buy, Rehab, Rent, Refinance, Repeat.
Step 1 – Buying
There are 3 basic parts to buying any property – finding, analyzing, and closing the deal.
Finding a Deal
The most important part of the BRRR real estate strategy is to find great deals. Without an amazing deal, it simply doesn’t work (but that’s kind of true about making money in real estate anyhow).
In general, people refer to deals as either “off-market” and “on-market.” An off-market deal is essentially every sale that is not listed with a real estate salesperson on a listing service such as the MLS, LoopNet, or CoStar.
There are a ton of ways to find great off-market deals. These includes:
- Starting an Investor Website
- Direct Mail
- Knocking on Doors
- Bandit Signs
…and a couple dozen more methods. The only thing limiting you is your imagination!
Analyzing Rental Property
It’s important to have a couple different calculators to get this job done. The most important is your “back of the napkin” calculator.
The reason why a calculator like this is so important is because you will literally look at hundreds of deals. It’s impossible to use an advanced calculator and cull through dozens of deals a week.
Instead, it’s best to use a very simple calculator, toss in the basic numbers, and just see if it’s even remotely close.
Once you do that, you can take the deal and do a deeper analysis. If it’s not any good, just toss it aside and you’ve saved hours of your time.
I put together a free BRRR calculator for you to use to screen deals.
The most important part of closing a deal is….financing it.
We’ll talk a bit more about financing at the end when we talk about the third R – Refinance, but it’s important to know that your financing up front will be different than how you refinance the deal.
Up front, you are generally using cash or some kind of private or hard money. Banks don’t like risk, and deals that need work are considered risky.
By using cash or private money, you’ll be able to purchase something with a bit of risk so you can add value.
The other reason is because distressed properties often need to close quickly. Banks are anything but quick.
So the key here is to use private money to purchase, then refinance into something longer term such as a good conventional or long-term commercial loan.
Step 2 – Rehab
You don’t want to rehab a BRRR rental property the same way you would fix a flip.
When you analyze a project for a flip, you look at the cost of the work vs the increase in value. If a kitchen costs 10k and increases the value by 15k, then it has a 50% return (15k – 10k = 5k return. A 5k return divided by 10k invested = 50% return).
That same kitchen may add value to your rental, but since you aren’t selling it, it’s the wrong way to measure value.
That $10k might add $15k in value, but add barely anything in extra rent. Since we are looking for cash-flow, I’d rather focus on renovations that add to the amount of rent I can charge.
BRRR Step 3 – Renting The Unit
Finding great tenants that will pay market (or higher) rents is key to your strategy. The 3 key steps are to find, screen, and retain.
Step 4 – Refinancing
The goal is to get your money back so you can repeat the process, which makes this step the most crucial.
because the rules for commercial lending are slighting different than personal lending, let’s take a quick step back and go over the rules/requirements for commercial lending:
- You will need around 2 years of “experience.” This can be rehab experience, landlord experience, or even experience as a realtor if you can convince the bank that it’s directly applicable.
- Most banks require 6+ months of “seasoning” before they will finance it at the market price rather than the purchase price. This means the property has been stable, fixed, and rented for around that period of time. Basically, they need you to justify the higher price with some evidence of stability and improved rents.
- Banks lend 75-80% of appraised value on this sort of deal.
It’s not hard to see the “trick” once all the criteria are laid out.
- Banks will lend around 75% of the appraised value after 6 months of seasoning.
- House flippers are looking to be “all in” for around 75-80% of the property value.
So, buy a rental property like you’re going to flip it, then just refinance it – you’ll get all your cash back plus long-term rental income.
But, in order for this system to work well, you need to be able to be “all in” for around 75-80% of value.
Step 5 – Repeat and BRRR More (aka brrrr)
Once you have most or all of your money back, it’s time to find another real estate deal to BRRRR! The extra R stands for Repeat.
You’ll have your cash back and a new stream of income. Could life get any better?
Have you ever used the BRRR Strategy? Tell me how it went in the comments below.