 # Terms Every Real Estate Investor Should Know Debt-to-Income (DTI) Ratio

The Debt-to-Income (DTI) ratio is the percentage derived from your gross monthly income which is used in making payments for your monthly debts. This is mainly used by money lenders to ascertain the level of risk for borrowing you money.

In other words: The Debt-to-Income (DTI) ration calculates the amount of revenue a person (or sometimes an organization) generates in other to pay off a debt incurred. Om average the highest DTI ratio a person can have to be eligible for a mortgage is 43%. This means the lower the DTI of a borrower, the more the person is able to service a debt.

A low DTI shows a good balance between income and debt. This means the person would be able to service a debt. For example, if Mary has a DTI ration of 16%, this means that 16% of her monthly gross income goes to payment of debts every month.

On the other hand, a high DTI ratio sends a red flag that the person has many debts for the amount earned every month.

It goes without saying that when an individual has a low DTI ratio, they would be able to manage their monthly debt payments without hassles which explains why most banks and credit providers are more interested in individuals with a low DTI ratio.

This is paramount because they want to be sure the borrower doesn’t have too many debts already on their neck before approving loans to them.

The ideal DTI ratio defer from lender to lender. Generally, most financial credit providers prefers a DTI ratio that’s lower than 35% with no more than 25% of that debt going into debt payments.

However, the highest DTI ratio an individual can have to be eligible for a loan is 43%.

DTI= Total Monthly Debt Payment

Gross Monthly Income

Your Gross Monthly Income is the total amount of money you’ve earned before your taxes and other deductions are taken out.

Here’s an example:

Mary pays:

$1000 per month for her mortgage.$200 per month for an auto loan.

$500 per month for electricity and rent. Mary’s total monthly debt payment will be:$1000 + $200 +$500 = $1,700 If Mary’s gross monthly income is$7,000 then, Mary’s DTI ratio would be:

DTI= Total Monthly Debt Payment

Gross Monthly Income

DTI= $1,700$7,000

DTI= 24%

This means Mary’s DTI ratio is 24%.

Loan-to-Value (LTV) Ratio

The Loan-to-value (LTV) ratio is a measure carried out by lenders and other financial credit providers to assess the risk of approving a mortgage to a borrower. The higher the Loan-to-value (LTV) ratio, the more it’s considered a high risk loan.

It’s often used in lending of a mortgage to ascertain the amount that would be required to put in a down-payment as well as to determine if the lender will extend credit to a borrower.

Typically, when the LTI ratio is very low, lenders tends to offer a mortgage to potential borrower at a low interest rate.

The Loan-to-value (LTV) is calculated by dividing the amount borrowed by the appraised property value expressed in percentage.

Which means:

LTV= Mortgage Amount

Estimated Property Value

Here’s an example:

If John wants to buy a house that’s estimated at $150,000 for its property value but the owner is willing to sell it at$140,000 and he makes a down payment of $20,000. His loan would be$120,000.

In other words, John’s Loan-to-value (LTV) ration would be:

LTV= Mortgage Amount

Estimated Property Value

LTV= $120,000$140,000

LTV= 85%

This means John’s LTV ratio is 85%.

Cash on Cash Return (COC)

Cash-on-cash return is one of the important calculations that’s done in real estate transactions to determine the rate of return and cash income that’s earned on an invested property. Typically, it measures the annual return an investor has made on a property as it relates to the amount of mortgage and expenses the investor paid during the same year.

In other words, it measures the gain or loss of an investment on a property at the end of the year compared to the initial cost of the investment expressed in percentage.

COC= Annual Pre Tax Cash Flow

Total Cash Invested

Annual Pre Tax Cash Flow = Annual rent – (Mortgage Payments + Expenses)

Total Cash Invested = Down Payments + Fees

Here’s an example to calculate the Cash-on-cash return:

Let’s say a company called Sally Corporations decides to buy a commercial space for $1 million. However, Sally Corporations made a down payment of$400,000 and takes a mortgage of $600,000 from a financial credit facility. Aside the down payment, Sally Corporations is required to pay$30,000 for various fees as Sally Corporations intends to rent the commercial space to various businesses.

After a year, the annual revenue generated from renting the space to various businesses is $150,000. Also, the mortgage payments, principal repayment and the interest payments all amount to$50,000.

So, to calculate the Cash-on-cash return for Sally Corporations:

COC= Annual Pre Tax Cash Flow

Total Cash Invested

Annual Pre Tax Cash Flow = Annual rent – (Mortgage Payments + Expenses)

Total Cash Invested = Down Payments + Fees

The annual cash flow of Sally Corporations in the first year is:

Annual Pre Tax Cash Flow = Annual rent – (Mortgage Payments + Expenses)

Annual Pre Tax Cash Flow = $150,000 – 50,000 Annual Pre Tax Cash Flow =$100,000

The total cash invested by Sally Corporations in the first year is:

Total Cash Invested = Down Payments + Fees

Total Cash Invested = $400,000 +$30,000

Total Cash Invested = $430,000 Using the information above, the cash on cash return for Sally Corporations in the first year is: COC=$100,000

$430,000 COC = 23% This means Sally Corporation’s COC ratio is 23%. Return On Investment (ROI) Return on investment is an important metric in real estate as it determines the amount money that’s made for an investment in relation to its cost over a particular period of time. This metric gives a full picture of how well investment dollars is being used to generate profits. To calculate the Return On Investment (ROI), here’s the formula: ROI= Gain on Investment – Cost of Investment Cost of Investment For example, if John buys a real estate property for$5,000 and sells it 3 years after for $7,000. The net profit (Gain on Investment – Cost of Investment) would be$2,000. In other words, the return on investment on the property is:

ROI= Gain on Investment – Cost of Investment

Cost of Investment

ROI= $7,000–$5,000

$7,000 ROI=$2,000

$7,000 ROI= 28% This means the return on investment of John’s real estate property is 28%. Debt Service Coverage Ratio (DSCR) The debt service coverage ratio is a measurement to determine a company’s cash flow in a bid to ascertain if they would be able to pay a current debt obligation. It’s mainly used by bank loan officers and credit providers to analyze individual borrowers, firms, and companies to determine income property loans. DSCR= Net Operating Income Total Debt Service For example, if Mary’s real estate property has a net operating income of$3 million and an annual debt obligation of $1.5 million, the debt service coverage ratio would be: DSCR= Net Operating Income Total Debt Service DSCR=$3,000,000

$1,500,000 DSCR= 2% This means the debt service coverage ratio for Mary’s real estate property is 2%. Capital Expense (Cap Ex) Capital expense is the money that’s used to improve a particular real estate property over a specific period of time. It is mainly used for fixed business assets, real estate properties, and equipments. Since the capital expense is always substantial, most real estate investors keep aside some cash from their monthly revenue to put in the reserves. Vacancy Rate The vacancy rate is the percentage of the total available spaces in a rental property over a period of time. This could be a hotel or an apartment complex. A high vacancy rate indicates that the property is not a good investment option as people don’t want to live in that region which could as a result of several reasons (overpriced, outdated construction, low quality, bad location etc) while a low vacancy rate shows the property is renting well. The vacancy rate of a particular property is calculated by adding up the total number of units that are vacant and multiply it by 100 and then dividing the result by the total number of units. In other words: Vacancy Rate= Number of Vacant Units ×100 Total Number of Units For example, if a property has 80 office space units and 12 office space are unoccupied, the vacancy rate of the commercial property is calculated thus: Vacancy Rate= 12×100 80 Vacancy Rate= 1,200 80 Vacancy Rate= 15% This means the vacancy rate of the commercial property is 15%. Cash On Equity Cash equity is a term used in real estate to refer to the amount of home value that’s greater than the mortgage balance. In other words, it’s the value of a property that is not borrowed against a line of mortgage. For example, if a commercial property owner purchases a Duplex that’s worth$130,000 for $100,000 and made a 20% down payment. The property owner has a$20,000 in cash equity and \$30,000 in market equity.

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