Understanding The Need To Know For Real Estate Investors
Investing in this day and age can be a very smart venture if you know what you are doing
. However, real estate investing can be a challenge, as well.
Don't forget--you are still in control. Maximize your own chances for success by making sure that you thoroughly understand the entire process, and all of the legal jargon.
Learn about the the financial dynamics that are at work in income-producing real estate. Whether you're scrutinizing a piece of property you already own, one you want to sell, or one you may choose to buy or develop, you need to master the metrics.
The numbers always matter. A simple one to begin with is the concept of vacancy.
What percentage of the property's total potential gross income is being lost to vacancy? Start off by collecting some market data, so you will know what is typical for that type of property in that particular location.
Does the property you own or may buy differ very much from the norm? Obviously, much higher vacancy is not good news and you want to find out why.
But if vacancy is far less than the market, that may mean the rents are too low. If you're the owner, this is an issue you need to deal with.
If you're a potential buyer, this may signal an opportunity to acquire the property and then create value through higher rents. Next, explore the LTV, or loan-to-value ratio.
When the financial markets return to some semblance of normalcy, they will probably also return to their traditional standards for underwriting. One of those standards is the Loan-to-Value Ratio.
The typical lender is generally willing to finance between sixty and eighty percent of the lesser of the property's purchase price or its appraised value. Conventional wisdom has always held that leverage is a good thing -- that it is smart to use other people's money instead of your own.
The caution here is to beware of too much of a good thing. The higher the LTV on a particular deal, the riskier the loan is.
It doesn't take much imagination to recognize that in the post-meltdown era, the cost of a loan in terms of interest rate, points, fees, etc. may rise exponentially as the risk increases. Having more equity in the deal may be the best or perhaps the only way to secure reasonable financing.
If you do not have sufficient cash to make a substantial down payment, then consider assembling a group of partners so you can acquire the property with a low LTV and therefore with optimal terms.
Debt Coverage Ratio, or DCR, is the ratio of a property's Net Operating Income (NOI) to its Annual Debt Service. NOI, as you will recall is your total potential income less vacancy and credit loss and less operating expenses.
If your NOI is just enough to pay your mortgage, then your NOI and debt service are equal and so their ratio is 1.00. In real life, no responsible lender is likely to provide financing if it looks like the property will have just barely enough net income to cover its mortgage payments.
You should assume that the property you want to finance must show a DCR of at least 1.20, which means your Net Operating Income must be at least twenty percent more than your debt service. For certain property types or in certain locations, the requirement may be even higher, but it is unlikely ever to be lower.
Planning a budget with a bit of breathing room might be a good principle for every government agency, financial institution and family to follow. Last but not least, consider the capitalization rate.
The capitalization rate expresses the ratio between a property's Net Operating Income and its value. Typically it is a market-driven percentage that represents what investors in a given market are achieving on their investment dollar for a particular type of property.
In other words, it is the prevailing rate of return in that market. Appraisers use Cap Rates to estimate the value of an income property.
If other investors are getting a ten percent return, then at what value would a subject property yield a ten percent return today? If this is not making sense to you, talk to a property lawyer today, and make sure you understand exactly what you are getting into, before you lose your money.
by: Jack Landry
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