Before you can analyze the merits of a for-sale listing you need to have a basic understanding of the property’s numbers. By that I mean you need to thoroughly understand:
- How a property is valued
- How a loan amount is calculated
- How a property’s cash-on-cash return is calculated
- How loan amortization impacts a property’s cash-on-cash return
- How leverage (the amount of debt borrowed to purchase the property) affects a property’s cash-on-cash return
“In your sleep”
You not only need to know the importance of these numbers, but you need to know how to do these calculations “in your sleep.” They need to become second nature to you.
In the first part of this five part series we discussed how a property is valued. Today we discuss how the loan amount is calculated. For some of you, this series will be very basic. You mastered these five real estate calculations long ago. You truly can do these calculations “in your sleep.”
However as I went through the process of writing these five articles I was surprised how many little tidbits I had forgotten, or maybe not forgotten but I hadn’t fully appreciated their significance. So for seasoned real estate professionals and investors don’t dismiss these articles out of hand as unworthy to read. I’m confident that there is content in these five blog posts that you will find of value.
CRE METRIC #2 – HOW THE LOAN AMOUNT IS CALCULATED
Calculating a property’s loan amount requires the use of a financial calculator. I have both a handheld calculator and an app on my smart phone. I recommend an HP 10bii financial calculator that you can get on Amazon for $24.99. Yes, you can go cheap and buy the HP 10bii app for $4.99 for your smart phone. You choose which option is best for you, but I much prefer the calculator.
Most loans are limited by the lower of a maximum loan-to-value ratio or a minimum debt service coverage ratio. But before we determine the loan amount based on these two underwriting parameters, we first need to understand the concept of Debt Service Coverage ratio (DSCR).
What is a Debt Service Coverage Ratio (DSCR)?
How to calculate a property’s DSCR
Shown below is how a DSCR is calculated:
For example, if the NOI for a property is equal to the total debt service for the property, the DSCR is 1.0. In other words, all the cash flow generated from the property is going towards servicing the debt. What happens if there is a temporary downward blip in the NOI which happens from time to time? Then there is not enough cash flow to pay the mortgage. This is not a good thing is it? In fact, if a property consistently has insufficient cash flow to service the monthly mortgage payment the owner will have to pay the mortgage from other sources of income or lose the property to foreclosure.
Lenders would much prefer an owner consistently pay his mortgage payments on time rather than go through the process of foreclosing on a property. To that end, lenders will require that borrowers have a DSCR greater than 1.0 to minimize the chances the borrower can’t pay his mortgage payment. Depending on the lender and the property type, I’ve seen DSCRs as slow as 1.15 and as high as 1.35, occasionally higher.
So what does a 1.25 DSCR mean? It means that that for every $1.25 of cash flow generated by the property, only $1.00 of it can be used for servicing the debt. The remaining cash flow goes into the borrower’s pocket to be used as he deems necessary including as a rainy day fund when the NOI is less than the monthly mortgage payments.
How to size the loan based a lender’s DSCR
Shown below is the same formula as the previous one, except now we are solving for debt service.
To illustrate, let’s assume you are purchasing a property for $1,000,000 and the lender uses the following criteria for calculating the loan size:
- 70% Loan-to-Value (LTV) ratio, or
- 1.25 Debt Service Coverage (DSCR) ratio whichever is less
Calculating the LTV loan amount is simple. It’s 70% of the purchase price or $700,000. Calculating the loan amount based on a 1.25 DSCR is bit more complicated requiring the use of a financial calculator.
It’s a two-step process:
Let’s assume the proposed loan terms offered include a:
- 5.0% interest rate
- 25-year amortization
How to calculate the maximum monthly mortgage payment
Let’s also assume that the property has a $60,000 NOI. You now have enough information to calculate the monthly mortgage payment which is the first step in the process:
Total Debt Service = $60,000 NOI ÷ 1.25 DSCR = $48,000
Monthly Mortgage Payment = $48,000 ÷ 12 months = $4,000 per month
In this case, $4,000.00 represents the maximum monthly mortgage payment that the property can support and still meet the minimum 1.25 DSCR required by the lender.
How to calculate the loan amount
The second step in the process is to solve for the loan amount, where
- PMT (payment) = $4,000.00
- N (number of months for amortizing the loan) = 25 years x 12 = 300 months
- I/YR = 5.0% interest rate
- Solve for PV (loan amount) = -$684,000 (rounded)
So what’s with the negative outcome? For financial calculations to work, one of the inputs or the outcome needs to be negative. Don’t let that bother you. Just forget about the negative sign. It’s irrelevant. The loan amount in this example is $684,000.
What is the maximum loan size for this property?
So what is the maximum loan amount based on the lower of a 70% LTV or a 1.25 DSCR? A 70% maximum LTV results in a $700,000 loan amount and a minimum 1.25 DSCR results in a $684,000 loan amount. In this case, the loan amount is constrained by the 1.25 DSCR. As you can see, it yields a lower loan amount of the two financing criteria limiting the loan to $684,000. And that is how the loan amount is determined. It is the lower of the maximum LTV requirement or the minimum DSCR requirement.
Those are my thoughts. I welcome yours.