When it comes to investing, a smart investor always uses numbers to guage the profitability before they take action. Whether it’s buying a business, purchasing stock, or buying a commercial property, analyzing the deal is imperative for making the best decision. We can sometimes get lucky on our investment if we don’t choose to run the numbers, but the odds aren’t in your favor. This would be like going to the casino and expecting to win $5,000 (which could happen), but the reality is that your chances of losing money are much greater. Don’t get me wrong, I love casinos! But when it comes to investing, making the right choice can save you much pain in the long run.
Let’s start with a single-family rental property. You’ve been roaming the streets for a few weeks and you finally see a house that stands out among the crowd. It’s a 3 bedroom, 1 bathroom house located in a decent neighborhood where rents are averaging about $650-$700 for this type of property. Let’s say that you agree to purchase the house at $40,000, which sounds like a good deal compared to others in the same area. Also, let’s assume you put down 20% of the purchase price in cash, leaving an 80% loan (at 8% for 20 years) on the remaining amount of the purchase price. Here’s one way of analyzing this one.
Monthly Rental Income: $650
Less: Vacancy (0% in this case) 0
Gross Potential Income $650
Insurance ($600/yr or $50/month) 50
Taxes ($1,500/yr or $125/month) 125
Reserves* ($1,200/yr) 100
Total Expenses: $295
Net Operating Income ($650 – $295) $355
Less: Debt Service (which means your loan payment) $268
Debt Service Coverage Ratio: 1.32x
*Reserves are an estimated amount of cash set aside for larger repairs, such as replacing a furnace.
As you can see, this analysis takes all the monthly income from the property, subtracts the expenses, then compares it to the monthly loan payment. This is how we arrive at the Debt Service Coverage Ratio (DSCR) shown at the bottom ($355/$268). In this case, the property has a DSCR of 1.32x times, which means that the rents from the property are 32% higher than the actual loan payment. This would be considered fairly good to most lending standards, who usually require a minimum DSCR of 1.20x on larger rental properties in order to stay within lending guidelines.
If you have any questions regarding this analysis, or have any likes/dislikes about this article or blog, please feel free to leave a comment. I really want to make my blog better. I can handle some constructive criticism!