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Debt Coverage Ratio, Cap Rate & Cash on Cash Return
Hi BP,
When analyzing an investment property 3 numbers are extremely important along with others;
1. Debt Coverage Ratio
2. Cap Rate
3. Cash on Cash Return
Most lenders look for DCR of 1.20 or better, most investors want at least 8% cap rate or better and a minimum of 10% cash on cash return (in majority of cases).
Keeping investor interest in mind,
Would it be a better deal, if investors gets a minimum of 1.5 DCR and say like 6-7% cap rate. I had situation where my DCR was 1.5 however my cap rate was around 6% only which I thought was too low.
I'd appreciate any suggestions / ideas on this matter.
As an Investor, you want all the numbers to be "healthy" (and healthy can be a wide spread for some categories). In my opinion the most important number is cash flow. As a buy and hold Investor, I have minimum targets for all kinds of numbers. And they typical all jive. In other words, if my cash on cash return is very low, so will the ROI, cash flow, IRR, etc. Figure out what is important to you and set minimums. I've built a spreadsheet that allows me to analyze any deal quickly. That way I'm only spending time on properties that have a chance of meeting my minimums.
To answer your specific question, I doubt investor's will care much about DCR and Cap Rate as much as their Cash on Cash Return, ROI, IRR, and cash flow. so the answer to your question is "Which of those situations has a better return on my investor money?" That's the one I choose :)
If you are relying on debt financing for your deal, the lender will care about DCR and by extension you will need to as well. If the proposed loan won't debt cover to the lender's satisfaction then more equity is required which will reduce the cash on cash return, all else being equal. Knowing your lender's DCR requirements beforehand will allow you to focus on deals that will work or at least capital structures that will work. After that hurdle is cleared then you can narrow in on those that provide the required investor returns as @Justin B mentions.
@Giovanni Isaksen "If you are relying on debt financing for your deal, the lender will care about DCR and by extension you will need to as well."
Like you comments above as when using leverage, one needs to make sure to satisfy lender requirements.
Originally posted by @Giovanni Isaksen:
I fully agree and didn't mean to imply it was unimportant. Typically, if the DCR is lower than what the bank wants, chances are the rest of the numbers aren't so hot either. What I meant to imply was that if your lender's requirement is 1.20 and you have satisfied it, there would be no reason for any other number to suffer to make 1.50 for example. Unless the bank gives you a much better rate for a higher DCR (which has never been the case in my experience), after securing financing, make the numbers work for you.
James,
I'm a little surprise that you get a 6% cap rate with a 1.5 DSCR. Would you mind sharing some numbers for clarification purposes?
First and most important is satisfying your lenders requirements. If you don't, you have no investment. There requirements are usually pretty conservative today so they should work out for you.
Just to step in here so people buying SFR, Duplexes, Triplexes and 4 Units. For conventional financing lenders do not look at the DCR, Cap Rate or Cash on Cash Return they look at a borrowers overall debt to income ratio using the borrowers personal income W2 or self employment and sometimes the rental property income depending on the program and borrowers landlord experience less the borrowers primary mortgage PITI and other monthly liabilities.
James- the true answer lies in the nature of debt and the size of the investment. For instance, I have a 40 unit investment purchased with seller financing- the cap rate is around 6% (seller Financed properties have inflated prices hence the lower cap rate), the cash flow is in healthy 5 digits;
So still a great investment given the nature of non-institutional debt and the great cash-flow.
We specialize in off-market deals & what we teach our clients is to not get stuck in cookie-cutter calculations but evaluate each deal in its own merit.
Cheers,
A.G.
RealAcquisitions.com
@Ed Wood like your thoughts a lot as well. It's very true that up to 4 units, lenders don't run numbers, but rather see debt to income ratio and borrower's strength. Having said that, 5 units or more it's where you have to worry about these figures.
Great posts everyone. I've been learning a lot since I've joined BP.
Regards.
I'm a commercial lender and I can tell you the number that gets tweaked the most is Cap Rate. As others have alluded to, the cash flow and DSC numbers are pretty straightforward calculations. Although I've seen some pretty questionable operating statements/pro forma NOI assumptions.
Also, you have to be really careful about generalizing on Cap Rates. We've seen institutional quality assets in the best markets trade in sub-5% cap rate range. With interest rates at historic lows, you have a lot of money chasing yield, and institutional money (eg pension funds, insurance co's, private equity) has been pouring into real estate. And in this lower rate environment, investors can afford to pay higher valuations (lower cap rates).
James,
When I saw your $30k acquisition cost, it makes sense why your cap rate is 6%. I guess you will use that $30k to renovate the 4plex?
When I think of multi-family, I think of 5+ units. Another factor that I forgot is that I can borrow $1M at 3.7% interest rate, not 5.25%.
Personally, I'm not a fan of buying $25k/door that gets $500/month in rent because the maintenance alone will kill your cashflow. Is 10% vacancy average for your area? When you're buying in this price range, I think you need to be closer to the 3% rule. I believe the sweet spot is in getting properties in the $50k-$100k that meet the 2% rule. Think about it, your maintenance is the same per sq.ft. regardless if it rents for $500/month or $5k/month.
To put things in perspective, my partner has a 2,000 sq.ft. house in Palo Alto that rents for $9,100/month. The maintenance on that house is the same as a $100k house that rents for $1k/month in Texas or elsewhere.
The property tax is so high in your area that makes your fixed carrying cost high. I believe you can cut that insurance down to $1,200/year, but it might be higher for your area. Your trash budget seems low, and why are you paying $400/year for advertising? That should have been built into the property management fee. We don't pay 1/2 or 1st month rent for any property manager here to fill the unit. Our PM is charging us 6% for management fee.
Of course, you have to deal with what your market is giving you. The numbers look good on paper, but when you break things down, the deal is too skinny for me.
@Account Closed Thank you for your detailed response.
Yes, I would have to renovate the property to bring up to a decent standard. In this area, decent units renting for $500 to $550 is running between $35,000 to $40,000. That's why I offered around $100,000.
I don't have that 2 year landlord history yet, therefore don't have many lenders to offer me loans. This local bank has loaned me loans so far and agreed to give further. Unfortunately, I had to pay 5.80% for first 2 properties and 3rd one (I protested) they offered me 5.25% and that's the lowest they would go at this time.
I would like to purchase bigger apartment buildings, however I don't have 20% down for those properties. For example, if I am buying an apartment building worth $1 million, I would need $200,000 for down payment which I don't at this moment (I am working towards that goal).
It's almost impossible to shoot for 3% in this area as suggested by you (appreciate it).
I agree about $400 about advertising as it should be cover under property management. About the insurance, that is the quote so far I got. I should try more insurance companies I assert.
Well, property mangement in this area is a minimum of 10% plus $100 tenant finding fee and in some cases first month rent.
Thank you everyone else to assist me.
One question for you @Account Closed Could you suggest any lender who is offering great terms and conditions for multifamily properties?
Warm Regards...............
James,
Unfortunately no. 5.25% for the loan your size is reasonable in my opinion. My commercial loan guy told us that he doesn't deal with loans smaller than $750k. Ideally, we should try to keep our loan size at a minimum of $1M. That's when he can offer us the best interest rate with no closing costs. Sorry for not being able to help you out in this situation.
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#3 Guru, Book, & Course Reviews Contributor
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James, good thoughts above, but there is a big difference here in the mid-west and Cali, no way 3% could be hit here, can't pull 2% except in a larger complex due to lower construction costs per ft. Look to on the after tax basis and the expected holding period with depreciation. :)
Hi James. It is SO easy to get hung up on specific numbers. There are actually a ton of factors that go into a purchase, not just the numbers. The numbers are, granted, the most important, but they aren't everything or the whole picture. Location, quality of property, tenant pool, etc. are huge factors as well. I would take a property with a lower cap rate ALL day long if it meant higher quality.
Remember, what is written on paper is just that, only written on paper. You want something with long-term returns, not just immediate. That's why I buy more expensive properties with lower cap rates, because they are typically much higher quality which increases my return over the long run exponentially.