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.
VIDEO: 4 Myths About Real Estate, Debunked!
From bubbles to recessions to risk, there are tons of myths surrounding real estate investments. Fortunately for you (and other WealthLAB addicts), most of them are untrue. In this video, WealthLAB’s investor/author Philip Michael debunks four myths about real estate investing.
What’s The Best Way To Invest $100K?
Let’s have some fun today and talk about the best way to invest $100,000.
It is a lot of money, but it’s also not a lot. You might have $100k after selling a house, rolling over a 401(k) or IRA, receive it as an inheritance, etc.
So, let’s dive into the best way to invest $100k.
Should I Diversify my $100k Investment?
The first thing to think about is diversification. Should I diversify?
This will depend on my current financial situation. If I have a bunch of other investments elsewhere, then I would consider dropping my $100k into just one investment.
If this was all of my disposable money that I want to invest, then I’d diversify it.
I will assume that this 100k is all the money available, so I’ll diversify it. But, if I ever wanted to dump it all in one place, I could just pick one of these categories and put it all in there.
Allocating My Money
Since I’m going to invest my $100,000 in a diversified fashion, I’m going to plan how to allocate the money first. In order to do that, I need to lay out some options to invest in first. Here are a few.
There are definitely more options but these are probably the most mainstream. I don’t want to dive deep into something that requires a lot of very specific knowledge or experience to get into.
Looking at this list, I’m going to cross a few items off right away.
Crossing Off My List
First, toss bonds. They earn too little and values are inversely related to interest rates. Since interest rates are going up, bond values are going down. Plus, who wants a few percentage points of return when everything else returns so much more?
The next thing I’d toss off is venture capital. The minimum investments are going to be too high and the cashflow is not there. Generally, VC companies have big pay days if they sell or go public, but won’t return any capital in between. I like good cash flowing assets.
The third item I’m going to toss is commodities. It’s an area where you can make a lot of money, but it requires a lot of specialized knowledge that most of us don’t have. Or, it requires a lot of speculation and that isn’t a solid investment strategy.
That leaves stocks, real estate, business ownership, and crowdfunding.
I personally would allocate my money into those 4 categories as follows:
I’m starting with crowdfunding because it’s easy to get started. I’ll be putting $20,000 of my $100k investment into this.
I’d jump right onto my favorite platform, Fundrise, and drop a portion of my investments right in there. The great part is you can invest with your retirement fund.
Investing With Fundrise
It’s a super simple process so this won’t take long.
I like Fundrise because it’s done well with the money I invested in it back in 2016. My return has average around 10% per year, and there has been some appreciation as well.
So, here’s how to invest with them:
First, go to the Fundrise website and pop your email address in there.
Next, select your plan.
Third, connect your account and fund the investment.
2. Direct Real Estate Ownership
I’d put 40% of my $100,000 investment money into my own real estate. At the $40k mark that allows me to buy a property that is roughly $200k in value. I can get a good triplex or fourplex at that price.
I think real estate is one of the best ways to invest money, regardless if you have $10,000, $50,000, $100,000 or even more to invest.
I’d expect at least a 15% cash on cash return and another 2-3% per year in appreciation. So, this $40k should earn around $7,000 per year for me.
Getting started in real estate is a little bit more challenging than just dropping money into crowdfunding. You can get started making offers in the next 30 days by checking this course out.
There are 4 things you need to learn in order to succeed at investing in real estate:
Find a Deal
Run the Numbers
Finance the Property
Fill it With Good Tenants
Finding Good Real Estate Deals
There are really 3 ways to find good deals – MLS, Direct Mail, or Online Lead Generation.
Of course, some deals are found by worth of mouth, knocking on doors, etc. But the 3 methods I mentioned are the only 3 that are truly scalable.
Finding Deals on the MLS
I’m not going to go into this too much, but, here are the basics.
First, find a good real estate agent. I like to use Agents Invest for a few reasons. First, the owner of the company is a real estate investor and she finds and trains agents around the country how to work with investors.
Second, it’s totally free to the investor.
Third, her agents often find deals that are not on the MLS, so it saves a lot of work for me.
Direct Mail Marketing
If you want to cut out the agent and go direct to the seller, a good way is with direct mail marketing.
In a nutshell, you buy a list of addresses, put together letters, and mail to them. Then, you wait for calls to come in.
Every time I’ve done this, I get about a 3% call back rate. So, if I mail 1,000 addresses, about 30 call me. Of that 30, maybe 3 are good deals and of those 3 I might get one.
In some markets, it’s more competitive so the numbers may be lower.
I go into a lot more detail on this method in my course on creating deal flow.
Online Lead Generation
Most questions start with a google search. Everything from “how do I avoid foreclosure” to “how do I sell my house fast” are all questions that people go to the internet to solve.
So, by creating that resource online, you might be the one they contact!
I use Investor Carrot for my online lead generation sites. Getting started with them is super simple too!
Simply go to the Investor Carrot site and pop in your email address.
Go through the prompts and set up your free trial.
Then start building content!
It does take about 3-6 months to generate any movement on Google, so be patient when first getting started.
Running the Numbers
This is the hardest part and there is no way we can get into it all here. But, we’ll cover the 4 basics you need to know, which are:
Determine After Repaired Value
Estimate the Rehab Costs
Know The Rents
Budget for Ongoing Operational Costs
Determining After Repaired Value
After repair value, or ARV is what the property will be worth after any necessary repairs are completed. Hopefully, the ARV is higher than whatever you are purchasing it for.
The goal is to buy it for a certain price, do some work, then have the ARV be significantly more than what you put into it.
The best way to estimate the ARV is to do a comparative market analysis (watch this video and subscribe)
Estimate Rehab Costs
There are a lot of rules of thumb and none of them apply everywhere. It also depends a lot on the size of the property in question.
The best way to estimate costs is to bring a contractor with you to give a rough idea.
You could use the $25/foot method which assumes a full interior upgrade costs about $25/foot, but that is fairly substantial.
There is also the $3,500 – $7,000 rule for interior upgrades on smaller apartments.
You get the point. It’s hard to estimate!
Know Your Rents
Similar to doing a comparative market analysis, you’ll want to look at comparable rents in the area.
Here are the keys to estimating rents:
First, find 3 or 4 apartments for rent in the area that have similar characteristics such as age, amenities, size, number of bedrooms, etc.
List their rent prices from cheapest to most expensive. If one is way out of alignment with the others, you want to know why. If it’s an outlier, I’d discard it.
Look at the remaining comparable apartments to see if they have rents that are similar then simply average them if it’s true. If they have a wide variety, then look to see which one is most like yours. Then, go find more apartments for rent that are more closely aligned with yours.
This is one of the biggest mistakes that most new investors make – they forget to budget properly for operational costs.
The easiest thing to do is to simply use the 50% rule. Basically, this says that 50% of your income will go your your expenses (everything except the principal and interest payments).
3. Create a Side BusinessI’d take $20,000 and invest it in a side project.
While this is not an entirely passive investment, it can become passive if it grows. Additionally, if it’s set up in a smart way, I can dedicate just a little bit of time to hopefully get outsized returns for the time commitment.
Honestly, not investment starts as completely passive, not even rental property. The key is to set it up well and have good systems in place.
There are two ways to go about this. I could start something completely unrelated to my other investments such as an eBay or Amazon FBA site. The other option is to start something that has synergy with one of my other investments.
Me personally, I’d rather have a business that ties in with other things I’m doing. So, I’d start a business related to real estate, but that isn’t actually investing in real estate.
4. Investing in Stocks
This is the most boring of all the options and the most well understood, so I’ve put it last.
I would invest the remaining money into a low cost index fund that tracks one or more of the major indices such as the DOW, Nasdaq, or S&P 500.
I’d probably divide my total investment between 2 or all 3 of them.
There are other low cost ETFs or funds that mirror other indices in the US or around the world, so you can get creative here and just go with the ones you think will perform the best.
For me personally, I like the S&P 500.
I’ve covered a lot of different ways to invest $100k. Like I said before, it really depends on your personal situation and risk tolerance.
It also depends on any other investments you might currently have as well.
VIDEO: How To Do Your First Deal In 5 Steps
(Also! If you want a great handbook for real estate, pick up Philip’s bestseller Real Estate Wealth Hacking: How To 10x Your Net Worth In 18 Months.)
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