Financial Ratios Used to Analyze Real Estate Investments

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.

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