- Written by Mike Hesse
Lenders, like other business people, have as their primary directive the intention of making money. A lenders process for doing so is by renting money.
In order to assist themselves in this process, that is in lending their money, collecting rent and having their original investment returned to them, they have developed formulas and guidelines upon which they rely. As in every arena, once a person understands the mindset of the participants and the rules by which they play, survival in their game becomes a much more likely and profitable experience. Specifically, investors who understand a lenders objectives and parameters greatly increase their odds of investment success.
The theory is this: a lender wants to make sure that the investor who comes to them seeking a loan on an investment property will have the capacity to pay them their required profit and then return their capital. They want both the return "of their investment as well as the return "on" their investment.
They figure that if the cash flow generated by the investment is great enough to: first, cover the total monthly expenses, second, to retire their debt and third, leave enough cash to cover any contingencies the odds of getting repaid is very high. One formula used by Lenders to determine the maximum loan that they can safely make on an investment or commercial property is the Debt Coverage Ratio (DCR).
The formula for the DCR calculation is: Net Operating Income (NOI) / Annual Debt Service = Debt Coverage Ratio. The process of arriving at the ratio is:
Gross Scheduled Income
Less: Vacancy
Less: Credit Loss
Equals: Gross Operating Inc. (GOI)
Less: Expenses (Operating)
Equals: Net Operating Income (NOI)
Less: Debt Service (DS)
Equals: Cash Flow Before Tax (CFBT)
Less: Taxes
Equals: Cash Flow After Tax (CFAT)
Today the DCR on most multi-family investments is approximately 1.20. (It is sometimes correctly quoted as 1:20 to 1.) Under I these guidelines, if an investor wished to acquire a ten unit building, the average rent for which was $800 per unit, and it had a 5% annual vacancy and 28% expenses, the numbers would look like the following:
So, the amount of money available to retire the debt (make the mortgage payments) on the property, the NOI, is $65,665. If we divide the NOI by 1.20 the result is $54,720 that is available annually to make payments and still leave some cash flow. Of course, while this CFBT represents a cash return to the investor, it means to the lender that there are funds to pay for contingencies that may arise and still not jeopardize their loan. (Just as one man's ceiling is another man's floor, one man's cash is another man's cushion.)
When we divide $54,720 by 12 we determine that the money available for monthly payments is $4,560. Therefore, on a loan amortized over 25 years at 9% interest, the maximum loan amount that a lender requiring a 1.2 DCR will make is $543,000.