Debt Ratios

When analyzing the personal budget of a borrower, lenders use two different debt ratios to determine if the borrower can afford his obligations. These two debt ratios are:

1. Top Debt Ratio

2. Bottom Debt Ratio

The "top" debt ratio is defined as:
Top Debt Ratio = Monthly Housing Expense/Gross Monthly Income

By "monthly housing expense" we mean either the borrower's monthly rent payments, or if she owns her own home, the total of the following -

Monthly Housing Expense

• 1st mortgage payment on home plus

• Real estate taxes (annual cost/12) plus

• Fire insurance (annual cost/12) plus

• Homeowner's association dues(if home is a condo or townhouse) plus

• Second mortgage payment (if any) plus

• Third mortgage payment (if any).

You will often hear the term P.I.T.I. It refers to (P)rincipal, (I)nterest, (T)axes and (I)nsurance. While P.I.T.I. is not exactly the same as Monthly Housing Expense because it does not include homeowner's association dues, the two terms are often used interchangeably.

Lenders have learned over the years that a borrower's "top" debt ratio should not exceed 25%. In other words, a person's housing expense should not exceed 1/4 of his income. While lenders will often stretch this number to as high as 28%, traditional lending theory maintains that anyone with a debt ratio in excess of 25% stands a good chance of developing budget problems.

The second ratio that lenders use to determine if a borrower can afford her obligations is the "bottom" debt ratio. It is defined as follows:
Bottom Debt Ratio = (Total Housing Expense + Debt Payments)/Gross Monthly Income

The only difference between the two ratios is the inclusion in the numerator of "debt payments." Debt payments include the following:

Debt Payments

• Car payments

• Charge card payments

• Payments on installment loans, for example - a payment on a washer & dryer that the borrower purchased.

• Payments on personal loans, for example - a signature loan from the borrower's bank.

What is not included in "debt payments" is Utilities such as PG&E, water or telephone and payments on real estate loans. Real estate loans are usually offset first by the net rental income from the property. If the borrower has a net positive cash flow from all his rentals, then the net income is usually added to his "gross monthly income." If the borrower has a net negative cash flow from all of his rental properties, then the amount of the negative cash flow is usually added to the numerator of the "bottom" debt ratio as if it were a monthly debt obligation, like a car payment.

Traditional lending theory maintains that a borrower's "bottom" debt ratio should not exceed 33 1/3%. In other words, the total of the borrower's housing expense and debt obligations should not exceed 1/3 of his income. Lenders often will stretch on this ratio to as high as 36%, and some have even been known to stretch as high as 40% or more. Obviously a loan with a debt ratio of 40% is a far more risky loan than a loan with a debt ratio of 32%.

Debt Service Coverage Ratio (DSCR)

The most important ratio to understand when making income property loans is the debt service coverage ratio. It is defined as:
DSCR = Net Operating Income (NOI) / Total Debt Service

To understand the ratio it is first necessary to understand the numerator and the denominator. Let's take a look at net operating income (NOI) first.

Net operating income is the income from a rental property left over after paying all of the operating expenses:

Gross Scheduled Rents                                    $100,000

Less 5% Vacancy & Collection Loss                $5,000

                                      ________

Effective Gross Income:                                    $95,000

Less Operating Expenses 

Real Estate Taxes

Insurance

Repairs & Maintenance

Utilities

Management

Reserves for Replacement

Total Operating Expenses:                                 $30,000

Net Operating Income (NOI)                $65,000

Please note that lenders always insist on some sort of vacancy factor regardless of the actual vacancy rate in an area to cover collection loss. In addition lenders always insist on using a management factor of 3-6% of effective gross income, even if the property is owner-managed. Their logic is that they would have to pay for management if they took back the property. Finally, NOTE THAT WE HAVE NOT INCLUDED LOAN PAYMENTS AS AN OPERATING EXPENSE.

Next let's look at the denominator, Total Debt Service. This includes the principal and interest payments of all loans on the property, not just the first mortgage. NOTE THAT WE HAVE NOT INCLUDED TAXES AND INSURANCE. They were already accounted for above when we arrived at net operating income (NOI).

To calculate the debt service coverage ratio, simply divide the net operating income (NOI) by the mortgage payment(s). For the sake of simplicity, let us assume that there is only one mortgage on the property:
$500,000 First Mortgage
11% Interest, 30 years amortized
Annual Payment (Debt Service) = $57,139

Then:
DSCR = Net Operating Income (NOI) = $65,000
Total Debt Service $57,139
DSCR = 1.14

Obviously the higher the DSCR, the more net operating income is available to service the debt. From a lender's viewpoint it should be clear that they want as high a DSCR as possible.

The borrower, on the other hand, wants as large a loan as possible. The larger the loan, the higher the debt service (mortgage payments). If the net operating income stays the same, and the loan size and therefore the debt service increases, then the lower the DSCR will be.

Life insurance companies are very conservative and generally require a 1.25 or 1.35 DSCR. This means that their loan-to-value ratios are low. Savings and loans (S&L's) generally only require a 1.20 DSCR, and sometimes will accept a DSCR as low as 1.10.

A DSCR of 1.0 is called a break even cash flow. That is because the net operating income (NOI) is just enough to cover the mortgage payments (debt service).

A DSCR of less than 1.0 would be a situation where there would actually be a negative cash flow. A DSCR of say .95 would mean that there is only enough net operating income (NOI) to cover 95% of the mortgage payment. This would mean that the borrower would have to come up with cash out of his personal budget every month to keep the project afloat.

Generally lenders frown on a negative cash flow. Some lenders will allow a negative cash flow if the loan-to-value ratio is less than around 65%, the borrower has strong outside income such as an electronic engineer, and the size of the negative is small. Lenders rarely allow negative cash flows on loans over $200,000.

Financing Options

Credit Lines
Under a credit line agreement, the lender supplies a business with funds intended to fill temporary shortages in cash that are brought about by timing differences between outlays and collections. Typically used to finance inventories, receivables, project or contract related work.

Short-Term Loans
Used for seasonal build-ups of inventory and receivables. Generally re payed in a lump sum at maturity, made on a secured basis and are for a term of a year of less.

Asset Based Loans
Lender advances funds based on a percentage of your current assets. The loan is used as source of funds for working capital needs. Lender typically takes a security position in the assets owned by the business.

Contract Financing
Funds are advanced to you as work is performed. Payments by the contracting party are generally made directly to the lender.

Factoring
Factors actually buy your receivables and rely on their own credit and collection expertise. Essentially, your customers become their customers. Factoring is used by firms who are unable to obtain bank financing. The cost of financing is usually higher than other forms of S-T financing.

Term Loans
Used to finance your permanent working capital, new equipment, buildings, expansion, refinancing, and acquisitions. Commercial banks are the major source of funding. The term of the loan is based on the useful life of the assets being financed or collaterized. Your projected profitability and cash flow are two key factors lenders consider when making term loans.

Equipment and Real Estate Loans
Loans are fully secured by the equipment being purchased. Typically banks loan 60-80% of the value of the equipment and is repaid over the life of the equipment.

Lenders make long term loans secured by commercial and industrial real estate. The loan is usually made up to 75% of the value of the real estate to be financed. Repayment terms range from 10 to 20 years. Lenders also make second mortgages on real estate. The amount of the second mortgage is based on the appraised market value and the amount of the first mortgage.

Leasing
Can be accomplished through a bank, leasing or finance company. Your business will be subject to the same type of review as when seeking a loan, specifically cash flow of company, value of lease object and useful life. Lease terms range from 3 to 5 years. At the end of the lease, there are generally 3 options: purchase, renew and return.

3-15 YR Balloon loans
Balloon loans offer interest rates that are fixed for a period of years. Typically these loans are pegged to a treasury index. Terms are for 3, 5,7,10 or 15 years. The amortization schedules are generally for 20 or 25 years.

When a balloon loan matures at the end of the agreed term, the remaining principle balance outstanding is due at that time. The borrower can pay off the loan by either selling the property or refinancing. Investment property is typically owned for a previously defined period of time. Analyze your investment strategy before securing a balloon. Having to redo a loan is expensive.

Adjustable rate loans
An Adjustable rate loan will typically fully amortize with no balloon features. These loans may or may not have adjustment caps. The rate is determined by an index plus a margin. The indices used are generally U.S. treasury bond rates. Rates are adjusted at a certain point in time using either the current rate of the index in question or the average of the index for the prior year. In either event, the index used will correspond to the adjustment term. If the loan is a three year adjustable, then the index used should be the three year treasury index.

Some adjustable rate loans are fixed for an initial period of years and then will adjust after that period. For example a 5/1 adjustable is fixed for the first five years and there after will adjust each year. The index used will be the one year treasury rate.

Please note that commercial lending is not standardized as it relates to programs and to guidelines. Banks must meet certain federal standards, but the index, margin, amortization, term and fees are components that are controlled by the investor based on their risk profit analysis. Remember that this mortgage will be the greatest expense your investment property will be responsible for.

As such we recommend that you consult your real estate agent and your loan officer to assist in providing you with all the information needed to make a complete and accurate choice.

 

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