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What is Debt Service Coverage Ratio and Why it’s Important?

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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:

Debt Coverage Ratio

where:

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

Debt Coverage Ratio

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.

DSCR

Notice how a small change can suddenly change everything!

The Bank Will Reduce Your Loan

Image result for bank 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%

Even worse…

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.

This article originally appeared on IdealREI. Follow them on FacebookInstagram and Twitter.

Real Estate Investing

How to Invest In Real Estate Through Your IRA

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Investing in real estate can be a great way to grow your wealth, but did you know that you can use your IRA to invest in real estate? An IRA (Individual Retirement Account) is an investment account funded with pre-tax dollars and can be used to purchase investments such as stocks, bonds, or even real estate. Here’s what you need to know about using your IRA to invest in real estate. 

Rules & Regulations 

First and foremost, specific rules and regulations must be followed when using an IRA to invest in real estate. You must adhere to IRS guidelines regarding the types of investments allowed and how much you can contribute each year. 

The most important rule is that you cannot use the funds for personal benefit; any money used for personal benefit will be subject to tax penalties. 

Additionally, it’s important to note that the money in your IRA must be invested into a qualified trust company or custodian before it can be used for any investment, including real estate. 

Benefits of Using an IRA To Invest In Real Estate 

One of the major benefits of investing in real estate through an IRA is that all profits from the investment are tax-free until retirement age.

This means any profits gained from rental income or appreciation won’t have to be reported on taxes until you withdraw them at retirement (typically 59 ½ years old). Additionally, since a traditional or Roth IRA allows for up to $5000/year ($6000/year if over 50) contributions without triggering taxes on those amounts, this could provide more capital than if investing with after-tax dollars alone. 

This could give you more buying power when looking for a piece of property and create larger returns down the road with compounding interest. 

Drawbacks of Using an IRA To Invest In Real Estate

There are some drawbacks associated with investing in real estate through an IRA, such as using the money after retirement without incurring taxes and penalties on withdrawals before then.

Additionally, IRAs typically have higher fees than other investments because they require custodians or trustees who charge annual fees for managing the accounts. Also, since IRAs can’t borrow money against their assets or partner with outside investors, acquiring larger properties is challenging due to the limited capital resources available through an IRA account alone.

With proper research and planning, investing in real estate through your IRA may help increase your wealth while avoiding taxes on those profits until retirement age making it a potentially attractive option for many investors who want access to capital without being taxed prematurely.

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Business

How Big Real Estate Moguls Avoid Taxes (And How You Can, Too) 👀

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I was looking around Google for an old article on tax strategies and this five-year old video of myself happened to pop up.

I’m interviewing a tax expert about how real estate investors avoid paying taxes in perpetuity—AND how everyday citizens can do the same thing.

(Real estate—our TEMPLE I and TEMPLE II projects included—has a number of tax benefits savvy investors have capitalized on for years, including Opportunity Zone breaks and 10-year tax abatements.)

There’s the 1031 exchange, of course, which I’ve shared with you guys before. 

Just to refresh your memory, the 1031 Exchange allows you to roll over gains from your last project into a new property TAX FREE—as long as said property is worth the same or more.

But there’s ANOTHER TAX LOOPHOLE that can take your portfolio to an entirely new level by splitting your capital gains into MULTIPLE properties.

So I thought I’d share it with you guys. 💎

You can check it out here.

Let me know what you think. 😎

PS: In our next update, I’m going to break down how real estate moguls get paid from their properties…tax free. 👀
PPS: If you want to learn how to implement generational wealth strategies like this one, you can join our NYCE wealth academy (TRIBE U) here.

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Business

How I run a $300M+ business from the beach…(and how you can TOO!)

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Yes, you read that right.

If there’s anything the pandemic taught us, it’s that the paradigm of “office” and “workspace” has been shaken to its CORE.

Universities are teaching via Zoom, court dates are done virtually, FULLY REMOTE businesses are valued at $1B+, and legitimate Inc. 5000 startups are run from…wherever. 📲

This is my office for the day…

I am actually running our business from the beach, typing this from here.

It’s 4:28 pm CET, which means it’s 10:28 am EST and I am CRUSHING my to-do list.

(And the team will continue to crush it while I’m asleep. That’s the 🗝)

So how did we get here? 

We launched NYCE and our mission to create 100,000 millionaires in March, 2020…just as the global COVID-19 lockdown happened. 😳

As a result, we shut down our main office and set EVERYTHING up to run remotely…

SMOOTHLY! And a system that allows us to outperform competition by 200%. (You can build this system, too. More on this in a second.)

Here’s what we were able to do since then:

  • Gained 6M+ followers across all platforms 📈
  • Add 1500+ new apartments to the portfolio 🤑
  • Grow to $300M in real estate 🚀
  • 105% investor returns 🎉
  • 700K+ community members 🤝

And here’s the best part…

Having team members in all the main time zones gives us a 24-hour work cycle vs. 9-5/eight-hour on-the-clock performance.

This means we get 3x the productivity of a similar company. 🔥

Let me repeat that…3x PRODUCTIVITY vs. our competitors.

Meanwhile our project management software grants us 24-hour TEAM-WIDE connectivity that tracks all tasks and lets us know if productivity dips even a little bit.

There is ALWAYS someone senior awake. It could be Martin in Barcelona…Nat in New York…Vineet & Arif in New Delhi.

All the while giving YOU GUYS wealth hacks and daily content. 🔥

OK, so how can you do it?!

Well, the first step is to have an actual side hustle you’re launching. Not just an idea, a validated business.

MAJOR KEY: Do NOT spend money until you’ve made your FIRST DOLLAR! 🗝🗝🗝🗝

(You can catch a replay Business Launch masterclass here and see TRIBE member Nessa launched her business on the spot and got her first $45K client shortly after.)

One of the easiest ways to start is with Airbnb—you can start that in 10 minutes. Literally. (Here’s a guide if you need it.)

Once you have your business, you build a virtual infrastructure (you really just need two softwares, which are FREE), manage the team accordingly and run the business from there.

I’m gonna put together a step-by-step video breakdown this weekend inside the new TRIBE U on the FIVE key things you need to do this for YOURSELF. 💵 💎

From what software to use, how to build a team, how to keep.

In the meantime, drop a comment if you’re ready to build some wealth and any questions if you want more…

Let’s get to work. 🙌

PS: If you can’t be bothered with video and just wanna get to work, we’re hosting a TRIBE U workshop that will help you get this process started on the spot. It’s $479 $49. 🔥

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