Financial Ratios Used to Analyze Real Estate Investments

Debt financiers often prefer debt service coverage ratio (DSCR) and loan to value (LTV) when arriving at the maximum loan on a definite property.

$$ \text{DSCR} = \frac {\text{Year one NOI}}{\text{Debt service}} $$

Where:

$$ \text{Debt service} = (\text{Interest} + \text{Principal}) $$

Note:

1. Payment of the principal amount leads to a reduction in the outstanding loan balance.
2. An interest-only loan doesn’t reduce the outstanding loan balance, making the loan balance constant over time.
3. Financiers prefer a DSCR of 1.2 or higher to guarantee that the property’s NOI can cushion the debt service.

The LTV ratio is arrived at as follows:

$$ \text{LTV}= \frac{\text{amount of loan}}{\text{value of appraisal}} $$

In circumstances where debt is utilized to finance real estate, equity investors calculate the equity dividend rate, also referred to as cash-on-cash return, and calculate cash return against cash invested in the first year of investment.

The equity dividend rate is arrived at as follows:

$$ \text{equity dividend rate} = \frac {\text{year one cash flow}}{\text{equity}} $$

Note:

1. The equity dividend rate only covers a single period of analysis instead of IRR, which calculates the entire holding period’s return.

Question

A financier will make an 8% interest-only loan on a property as long as the debt service coverage ratio is at least 1.6 and the loan-to-value ratio does not exceed 60%. What is the maximum loan amount, assuming the property just appraised for $1,800,000 and NOI is $400,000?

1. $250,000
2. $1,080,000
3. $3,125,000

Solution

The correct answer is B.

Using the DSCR equation:

$$ \begin{align*} \text{DSCR} &= \frac {\text{year one NOI}}{\text{debt service}} = \frac {$400,000}{1.6} = $250,000 \\ \text{loan amount} & =\frac {\text{DSCR}}{\text{interest rate}} =\frac {$250,000}{8\%} = $3,125,000 \end{align*} $$

Using the LTV ratio:

$$ \text{LTV} = \frac {\text{amount of loan}}{\text{value of appraisal}} $$

Substituting for the amount of loan in the equation:

$$ \begin{align*} \text{loan amount} & = {\text{LTV}} \times \text{value of appraisal} \\ & = (60\% \times $1,800,000) \\ & = $1,080,000 \end{align*} $$

Hence the maximum amount of loan, which is the lower of the two amounts, is $1,080,000.

A is incorrect. It indicates the DSCR amount.

B is incorrect. The amount exceeds the LVT ratio of 60%.

Reading 36: Investment in Real Estate Through Private Vehicles

LOS 36 (e) Calculate and interpret financial ratios used to analyze and evaluate private real estate investments.