Landlords need to understand these key metrics to be able to prove their investments profitability and secure favorable loan terms.
When reviewing financing options for new investment properties, real estate investors need to be able to prove to lenders, and themselves that not only is their current portfolio profitable, but that any potential property they are looking to invest in would be a valuable addition to their portfolio.
Lenders want to determine a number of things, primarily though they want to know that you will have the cash flow to pay your debts, including any new debts. The more leveraged you become the riskier the loan is for them. To mitigate this risk, lenders will offer less favorable loans with higher interest rates, or they will simply deny you.
In this article, we outline 3 ratios that real estate investors should review which will allow them to prove to lenders and financial institutes the value of their current portfolio and the value of prospective investments. These ratios look at key figures such as expenses, cash flow, and leverage.
The loan-to-value (LTV) ratio is an assessment of lending risk that financial institutions and other lenders examine before approving a mortgage. Typically, loan assessments with high LTV ratios are considered higher risk loans.
The loan to value ratio (LTV) is often used by financiers such as mortgage lenders to determine the amount necessary for the investor to put in as a down-payment. Generally, lenders offer applicants the best rates when the loan to value ratio is below 80% eg. the applicant is putting in a 20% or greater down-payment.
The formula to calculate the LTV ratio of a home:
LTV Ratio = Appraised Property Value (APV) / Mortgage Amount (MA)
Lenders look at the LTV to determine the risk level associated with giving out a loan. The greater the risk level the higher the interest rates generally are. The lower the LTV ratio, the greater the chance that the loan will be approved and the more likely the applicant will get a more favorable interest rate. In addition, as a borrower, a lower LTV ratio means the less likely that you will be required to purchase private mortgage insurance (PMI).
The Debt Service Coverage Ratio (DSCR) is used by lenders to determine the ability of a company, or loan applicant, such as a landlord, to repay all of its debt obligations. This includes repayment of the principal and interest on both short and long-term debt.
The debt-service coverage ratio applies to corporate, government, and personal finance. In the context of real estate investors, the debt-service coverage ratio (DSCR) is a measurement of the investor’s available cash flow to pay current debt obligations.
The formula for the debt-service coverage ratio requires net operating income and the total debt servicing for the entity. Net operating income is a company’s revenue minus its operating expenses, not including taxes and interest payments. It is considered the equivalent of earnings before interest and tax (EBIT).
DSCR = Total Debt Service / Net Operating Income
When: Net Operating Income = Revenue − Operating Expenses and Total Debt Service = Current Debt Obligations
Lenders will routinely assess a borrower’s DSCR before making a loan. A DSCR of less than 1 means negative cash flow, which means that the borrower will be unable to cover or pay debt obligations without drawing on outside sources, ie. borrowing more.
In real estate, the operating expense ratio (OER) is a measurement of the cost to operate a piece of property, compared to the income brought in by the property. It is calculated by dividing a property’s operating expense (not including depreciation) by its gross operating income.
OER is used for comparing the expenses of similar properties. An investor should look for red flags, such as higher maintenance expenses, operating expenses, or utilities that may deter him from purchasing a specific property.
The lower the OER the better, though generally a good range to be in is between 60% and 80%.
The formula for Operating Expense Ratio (OER)
OER = Gross Revenue / (Total Operating Expense – Depreciation)
Because it does not include the market value of a property, it does not inform an investor about the relative value of a property at purchase or sale. It only speaks to the efficiency of ongoing operations. As such, this is a particularly interesting metric as it enables an investor, or lender to determine the current managerial efficacy of the property owner or manager.
There are plenty of numbers that you can look at when determining whether or not a property is a good investment from the Cap Rate to the Gross Rent Multiplier. Ultimately though, you want to be proving one key thing, and that is, at the basest level, that more money will come in than go out.
There is a range of strategies that investors implement to minimize overheads, mitigate taxes, and maximize profitability. These strategies include things like refinancing properties to lower loan interest rates, employing software to improve accuracy and efficiency of income and expense tracking, making property improvements, and maneuvers like a 1031 exchange to defer capital gains tax.
As such, it’s important to carefully track and record the ongoing cash flow of your properties, documenting leases and vacancy periods, to maintain strict oversight of your investment portfolio financials.