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How to Finance Investments: Part 1

Posted by 15789465 on

There's a lot to say on this subject.  I'll break it down into little pieces and separate Posts. For this post, I'll cover one of the first things lenders look at—Debt Coverage Ratio, also called DCR.  Some lenders call it the DSCR—Debt Service Coverage Ratio. It is a comparison between the anticipated mortgage payments and some of the cash flows from the investment. Usually a lender wants a DCR of 120% to 125% You should interview potential lenders before making a loan request.  Ask about their underwriting requirements.  The DCR is an underwriting requirement. Each lender has specific rules about their requirements for the type of property you want to buy and finance. I'm going to explain how you can calculate the DCR yourself to see if you will meet a potential lender's requirements. Remember, just because one lender won't finance you doesn't mean NO lender will finance you. They all have different rules.  Also, once you know how things work, you can "tweak" your numbers to fit into a lender's guidelines. There is nothing illegal or unethical about this. I explain how you do it, at the end of this Post. To find the DCR, you start by taking the gross rents you would collect from the property for a year if it were rented 100% of the time at market rents.  Let's suppose that's $800 a month for 12 months, or $9,600 "gross scheduled rent." Then you subtract 5% to 10% of that number (depending on the lender) for a vacancy and concessions factor.  Concessions means renting the property for less than full market rent, because that's what you had to do to get a tenant in. Maybe it's cheaper rent, maybe it's two weeks free, etc. Let's use 10%. That gets us down to $8,640.  When interviewing potential lenders, ask them what they use as a percentage for vacancy and concessions on your type of property.  They know the percentage, they just don't volunteer it in a conversation. Next subtract all the anticipated operating expenses for the property. That will include real estate taxes and insurance. It could include lawn care and maintenance. A larger property might have office staff, maintenance people, etc. Even if you maintain your own rental properties, you'll need to buy supplies and parts, and some work might require a third party. Some lenders require you to include a property management fee as an expense, even if you self-manage.

♦  When shopping for a lender, ask them about whether they impute a property management fee even if you self-manage.  It might be harder to obtain a loan from a lender that says they will evaluate your numbers using higher expenses than you will really have.

After subtracting all those expenses, the number that is left is called Net Operating Income, or NOI. Technically, advertising expenses and leasing commissions are not subtracted out to reach the number that commercial real estate brokers call NOI. But, some lenders subtract those numbers anyway.  This is something else to ask a potential lender. Some lenders will also require you to include an expense called "replacement reserves."  That is money set aside each year so you can save up enough money for big expenses like a new roof or replacing the appliances.  This, also, is an underwriting requirement. Some lenders require it in the financial analysis, some do not.  Find out which is which! The NOI is what is left over that you can use to make your mortgage payments. Hopefully some of that will be money you get to keep, also.  Let's suppose in our example that all those expenses add up to another $1,500 per year. That leaves us $7,140 in NOI.

All numbers are calculated using annual basis

Annual Rent ($800/month)

9,600

Less Vacancy & Concession of 10%

(760)

Equals Gross Effective Rent

8,640

Less Operating Expenses

(1,500)

Equals Net Operating Income

7,140

The lender will want to see that $7,140 per year is 120% or 125% of the annual mortgage payments, depending on their underwriting requirements. In other words, they want your Net Operating Income to be 20% or even 25% more than your annual mortgage payments. Let's suppose our lender has a required DCR of 120%  If that's the case, then you can have annual mortgage payments of up to $5,950, or $495.83 per month. In other words, if your NOI is $7,140, and your mortgage payments are $5,950, then your NOI is 20% more than you need to pay the mortgage.

All numbers are calculated using annual basis

Annual Rent ($800/month)

9,600

Less Vacancy & Concession of 10%

(760)

Equals Gross Effective Rent

8,640

Less Operating Expenses

(1,500)

Equals Net Operating Income

7,140

Lender’s Required DCR

120%

Convert DCR to a decimal

1.2

Divide NOI by DCR

7,140 / 1.2 =  5,950

The answer is the maximum annual mortgage payment you can have--$5,950
That leaves you a cushion of $1,190 per year.

♦  By the way, if your property will support mortgage payments of $5,950 a year, then that's a mortgage of around $76,000 if the interest rate is 6% and the term is 25 years.

Now that you understand how this works, you can use it to get loans approved.  Suppose a particular lender requires a DCR of 120% but you need to borrow $85,000 rather than just $76,000. This is how you analyze the loan requirements:
Loan Needed

85,000

Annual pmts with 6% interest and 25 yr term

6,572

Required DCR

120%

6,572 / 1.2 = Required NOI

7,886

Actual NOI in example

7,140

NOI must increase to support the loan

746

How can we reduce the annual mortgage payments, and/or increase rent and/or reduce expenses to fit within the lender’s requirements?
In other words, play with your numbers after you find out the underwriting requirements and before you make a loan application.  You'll find a lot more of your deals getting approved. Next Post: What lenders want to see as far as your ability to make mortgage payments even if the property is vacant. The lender views the DCR cushion as money available for unforeseen expenses. Unless you have a very large DCR (140% or more), the cushion is not viewed as money available to pay the mortgage even if the property is vacant. You tell me. Did you already know this, or is this new information and you want more of the same kinds of stuff?

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4 comments

  • Hi Steve. Thank you! Please refer people to the blog site, so they can subscribe if they want to get their own emails. Thanks for recommending me!

    Denise L. Evans on
  • Wow… that is very good stuff to know! Yes, I know lots of investors who will love reading this! Is it best to refer them to the site or forward the e-mail to them!
    Thanks mucho!

    Steve Payne on
  • Poor Howard. I think you need to move to Baldwin County, where there are lots of opportunities for your knowledge and talents and a “clean slate” regarding local government! :)

    Yes, the advice applies to single family residences as well as apartments.

    If you want to buy foreclosures on the courthouse steps, I would recommend contacting the owner to gain access to the property ahead of time to inspect it. If it were me, I would offer the owner $500 if I end up buying at foreclosure. The owners gets his $500 the minute the auction is over and I’m told I’m the successful bidder. If I don’t get the property, thank you for showing it to me, but it didn’t work out and you don’t get any money. If I decide the house has too many problems and I don’t even try to bid, no money. $500 is a lot of money for people losing their home.

    If that doesn’t work, you are probably looking at getting money from one of the transaction lenders. It’s expensive money, but it’s designed to be short term money.

    Denise L. Evans on
  • does this apply to single residences?

    what about property that appears to be going to mortgage foreclosure or tax sale? how can u get financing lined up in advance when u don’t know if the property will sell and if it does there will be big repair costs (and municipal court expenses in huntsville to pay for our new jail)?

    howard ross on

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