3 Ways to Measure Your Financial Risk

A good rental property cash flow analysis typically makes computations associated with financing such as loan to value ratio, debt coverage ratio, and break-even ratio in order to measure the financial risk of an investment real estate property. These financial measurements are regularly examined closely by lenders attempting to determine the risk they will be taking to loan money on rental properties requested by real estate investors. But they speak to the investor as well because they reveal the financial risk he or she will be taking to purchase the property.

In this article, we’ll discuss the meaning and formula of each measurement so investors can learn to interpret them correctly when they examine a cash flow analysis.

1) Loan to Value Ratio The loan-to-value ratio (or LTV), a well-known measure of leverage, is the ratio between the rental property’s mortgage and the property’s appraised value or selling price, whichever is less. In this case, when the appraisal is less than the price you’re willing to pay, bear in mind that a lender will always lend on the lesser appraisal value regardless how much you argue. Expressed as a percentage, the maximum LTV (i.e., the most the bank is willing to lend) will vary according to property type. Whereas a lender might loan 80% on a single-family home you plan to occupy, you might be able to borrow only 70% (or even less) on an investment property because lenders regard income properties financially riskier and expect your investment equity to be greater. The reason is straightforward: Banks don’t want to lose money; they don’t want to take back a rental property in foreclosure and have to operate it while they try to sell it. With an investment property, banks understand that the property (unlike a personal residence) is all about the cash flow numbers, and they deem that the more money you risk losing, the more incentive you have to make the property profitable thereby reducing the bank’s risk. As an investor, obviously the higher your leverage (i.e., the more you can borrow and reduce your own investment) the better.

Formula: Loan-to-Value Ratio = Loan Amount/Appraised Value or Selling Price

2) Debt Coverage Ratio The debt coverage ratio (or DCR) is the ratio between the property’s net operating income (NOI) and debt service (defined as required annual payments of principal and interest). Expressed as a number, debt coverage ratio reveals the number of times that net operating income (i.e., the property’s income after operating expenses) exceeds debt service. If the NOI and debt service are exactly equal, then the ratio is exactly 1.0. When your DCR is less than 1.0, it means that that the property does not generate enough income to pay the mortgage, and conversely, a ratio greater than 1.0 signifies that the property does generate enough with some left over. The debt coverage ratio varies with lender and by property types and depends upon conditions in the economy, but obviously, a lender would certainly expect the property to generate more than enough income to cover the mortgage payments (i.e., greater than 1.0) to be sure that there is a margin for error.

Formula: Debt Coverage Ratio = Annual Net Operating Income/Annual Debt Service

3) Break-even Ratio The break-even ratio (or BER, and sometimes called the default ratio) provides the percentage of gross operating income that will be consumed by operating expenses and debt service. In other words, it estimates the proportion between the money coming in and the money going out. Expressed as a percentage, the purpose for BER is essentially to gauge how vulnerable a rental property is to defaulting on its debt should rental income decline. Lenders, of course, will use this ratio as a benchmark for their financial risk to insure that they will always get paid regardless of whether your property’s income weakens or wanes. As before, break-even ratio varies with lender and by property types, but they will generally look for a BER of 85% or less (i.e., they do not want more than 85% of the available income consumed by expenses and mortgage payment).

Formula: Break-even Ratio = (Debt Service + Operating Expenses)/Gross Operating Income

Okay, now that you’ve got the idea, allow me to make a suggestion. Real estate investors would be wise to examine these ratios as closely as lenders do when considering an investment real estate opportunity. As stated earlier, banks use them to measure their financial risk, and it just makes sense that you would benefit to use them to measure your financial risk as well.