Introduction to Leveraging: Understand Financial Institutions

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#1: Understanding Financial Institutions

Understanding financial institutions is the first step to leveraging the bank’s vault to increase capital.  Financial institutions lend money with the least amount of risk possible.  The more their perceived risk, the higher the return they require.

Unlock Financial Bank Vault

This information will help you as a real estate investor unlock the bank’s vault.  If the real estate investor can find ways to reduce bank risk, they are more likely to get more favorable loan terms such as lower interest rates and longer amortization periods.

It goes without saying that to be considered for leveraging, financial institutions will require a track record that is reflected in high credit scores.  Low credit scores indicate increased risk for the bank. Banks measure risk using metrics such as Loan To Value (LTV), Debt Coverage Ration (DCR), and Equity.
 

Loan To Value Ratio (LTV)

Financial institutions want to verify that people have an interest in paying back a mortgage.  The LTV measures “skin in the game.”  LTV is the ratio between the loan and the value of the property.  The higher the LTV the more the risk for the lender.  Low LTVs require investors to pay a higher down payment.

Formula: LTV=Loan Amount / Total Value

Example: Sally is buying a multi-family complex for $2 million.  She has been approved for a loan in which she pays $500,000 down.  What LTV is the financial institution requiring?

$1.5 mill/$2 mill = 75%

Typically investment loans backed by income producing real estate will be between 70% and 80% LTV.  The higher the LTV, the less the risk to the bank.

Debt Coverage Ratio (DCR)

The ratio between the net income on a property and the annual debt service.

Formula: DCR=Net Operating Income (NOI)/Annual Debt Service (ADS)

Example: If the NOI on a property is $100,000 and the ADS is $75,000 what is the DCR?

$100,000/$75,000 = 1.33

As real estate investors increase their portfolio, banks are looking for a minimum of 125% DCR on income producing properties.

Equity

Equity is the portion of the real estate the investor owns.

Formula: Equity = Value – Debt

Example: If Sally, the investor, buys a home for $100,000 and pays a down payment of $20,000, her equity is $20,000.  Over the next 5 years she completes some updates and pays the mortgage down to $75,000.  The value of the property goes up to $110,000, her new equity position is: $110,000 – $75,000 = $35,000.

Equity can help real estate investors plan for an exit or knowing the profit after the sell of the property.

#2: Measuring Leverage >>

© 2020 Jacob Grant