Keeping a long term view when investing in real estate is important if one wants to preserve positive cash flow levels during down times. Investors should measure how the property financial characteristics will perform in good and bad times before investing in the property.
Three financial indicators are crucial when planning for future economy cycles, namely Debt Coverage Ratio, Break Even Ratio, and Loan To Value Ratio. These indicators all have formulas that can be applied to investment properties, most investors use
real estate investment software do the calculations.
The Debt Coverage Ratio indicator determines whether the property generates enough money to cover the debt for the annual debt payments. A Debt Coverage Ratio of 1.00 means you have exactly, greater than 1.00 means you have enough and some left, and less 1.00 means you don't have enough to pay the mortgage. Most banks like the property to have a DCR of 1.20 or higher before they give out a mortgage. To counter measure future recessions one should only invest in properties with a Debt Coverage Ratio of 1.5 or higher; doing so should provide breathing room should rental levels fall and interest rate rise (if financed with variable rate mortgages). It also provides certain level of protection against inflation, which might increase the operating expenses of the property.
The Break Even Ratio is an indicator used by lenders when underwriting investment properties, its purpose is to estimate how vulnerable a property is to defaulting on its debt should rental income decline. The lower the Break Even Ratio the better; it typically ranges between 70% and 100%. To counter measure future recessions one should only invest in properties with a Break Even Ratio of 80% or less. This will protect against times when surplus of housing inventory is high and rent levels contract.
The Loan-To-Value or LTV is a ratio between the loan balance and the market value of a property expressed as a percentage. The LTV can be used to estimate the amount of equity you have in a property. The lower the LTV ratio the better; lenders usually want a LTV of 70% or lower. To counter measure future recessions one should only invest in properties with a Break Even Ratio of 70% or less. This counter measure allow investors to preserve equity in their investment properties should housing prices drop.
Other real estate financial indicators such as Gross Rent Multiplier, Profitability Index, and Internal Rate of Return are also important when assessing real estate investments.
Real estate investment software is available to calculate these indicators automatically once the basic property’s financial information is entered.
Remember that economies have ups and down; this phenomenon should not be perceived as a negative aspect of capitalism, rather as a natural correction process needed to maintain a sustainable economy and marketplace, thus planning for it should be part of every investor’s investment strategies.
