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The Two Key Numbers to Consider When Buying Your Next Real Estate Investment! 🤔🏘️
This post emphasizes the significance of the DSCR and Stabilized Yield in real estate investments for achieving financial success.
When it comes to investing in real estate, it's easy to get lost in a sea of data, trends, and market predictions. However, experienced investors know that amidst all the noise, there are two critical numbers that truly matter when making a sound investment decision: the Debt Service Coverage Ratio (DSCR) and the Stabilized Yield. In this post, we'll delve into why these numbers are crucial and how they can help you make more informed and profitable real estate investments.
1. Debt Service Coverage Ratio (DSCR): Your Ticket to Favorable Financing
The DSCR is a financial metric that measures a property's ability to cover its debt obligations, primarily the mortgage payment. It's a key indicator that lenders consider when determining whether to provide financing for a real estate investment. A DSCR of 1.25 or higher is the golden rule to aim for.
Here's why a DSCR of 1.25 is important:
a. Favorable Financing:
Achieving a DSCR of 1.25 or greater is often a prerequisite for obtaining favorable financing terms. Lenders view a DSCR above 1.25 as a sign that the property generates sufficient income to comfortably cover its debt payments, reducing the risk of default. This typically results in lower interest rates, longer loan terms, and improved overall financing conditions.
b. Risk Mitigation:
Maintaining a healthy DSCR is not just about securing financing; it's also about safeguarding your investment. A higher DSCR provides a financial cushion, making it easier to weather unforeseen expenses, vacancies, or economic downturns without putting your investment at risk.
2. Stabilized Yield: Where Profitability Lies
While the DSCR helps you secure financing, the Stabilized Yield is where you make your money in real estate investments. Stabilized Yield refers to the return on investment you can expect once the property reaches a stable, income-producing state. It is calculated by comparing the property's net operating income (NOI) to its current market capitalization rate (cap rate).
Here's why Stabilized Yield is crucial:
a. Predictable Returns:
Stabilized Yield provides a clear picture of your investment's potential for generating predictable and sustainable returns. By stabilizing the property's income stream, you reduce your reliance on macroeconomic factors and market volatility, which can be beyond your control.
b. Value Creation:
When you can stabilize the property's yield above the current market cap rate, you're effectively creating value. This means your investment is outperforming the broader market, and you have the potential for capital appreciation, increased cash flow, and a more profitable exit strategy when you decide to sell.
To illustrate the importance of these two key numbers, let's look at a real-life example:
Real-Life Success Story
In 2020, I purchased a 6-story, 56-unit mid-rise apartment building built in 1997 for $3,350,000. I bought it with a 1.25 Debt Service Coverage Ratio (DSCR) to meet the criteria for a 75/25 Loan-to-Value (LTV) financing structure.
At the time of purchase, the value add was obvious, with the rents lagging behind the market by approximately $200 per unit and needing only a very light freshening up. Today, the property is stabilizing around a 14% yield, with market cap rates currently around 6.5%.
This success story exemplifies the power of focusing on the DSCR and Stabilized Yield. By securing favorable financing through a strong DSCR and creating value through a high Stabilized Yield, this investment has proven to be a wise and profitable choice.
So how do I use these metrics as an investor and what does this tell me?
This is very simple, if you find a property that has a in place NOI that produces a DSCR of 1.25x and if the stabilized yield is at least a couple percent higher than the cap rate in the local market, you have a deal.
By stabilizing the property at a minimum of a couple percent higher than the local cap rate, it’s probably a good deal.
In conclusion, when it comes to real estate investments, it's essential to focus on the two most critical numbers: the DSCR and the Stabilized Yield. While a strong DSCR helps you secure favorable financing terms and mitigate risk, the Stabilized Yield is where you truly unlock the profit potential of your investment. By diligently analyzing and optimizing these two numbers, you can make smarter, more profitable real estate investment decisions, even in a dynamic and ever-changing market. This is how you buy real estate.