Now, I'm going to tell you how I teach Debt Coverage Ratio when I'm in the class. It's expressed as a ratio between the net operating income and the mortgage payment.
When I put the numbers into the cash flow analyzer and I've got it all in there correctly, I go to the cash flow analysis tab, and scroll right down to the DCR. That's the first financial measurement that I even look at because that tells me whether I can make this a deal or not. It tells me whether the price of the property that the broker told you was way out of whack. It tells me whether my offer price is way out of whack.
Just by understanding the debt coverage ratio, I know whether I did the analysis correctly or not. And that's why I love the DCR.
This is how I teach it for those of you that have never been to one of my classes. What you need to do in your mind is when you hear the number, the DCR, change that number into a dollar value. It's like if the guy says it's a 1.3, think of that as $1.30.
And what that means is that, for every $1.30 the property earns in net operating income, the bank gets a buck and you get the 30 cents. And that's all you have to cover capital expenditures and to pay your investors. So think of the debt coverage ratio that way.
That's why you can't always just say, "Oh, 1.2, that's all you need." No, 'cause you've got so many other factors in there that you need to take into consideration - that a static number for your debt coverage ratio is not going to work.
I use this example here, if I did $1.30, or 1.3 debt coverage ratio, good deal or a bad deal?
It depends! You can't just say one number is okay. You have to understand more about the deal, more about the property in order to determine whether that debt coverage ratio is the right one.
I have rules of thumb that I use for debt coverage ratio :
A class A property can live with a lower debt coverage ratio than a class C property. The reason is because you have to think about these properties as living, breathing dynamic organisms, and all of them are different. A class A property has the people who pay their rent on time every month. A class C property is not, you don't have a doctor living there. You have people that will move out overnight in the dead of night if they fall behind on their rent. And they're looking for the first month free concessions. So it's a totally different type of clientele.
The reason why we can go with different types of debt coverage ratios is because different types of clienteles handle things differently. They pay their bills, they don't fall behind. And you have to understand that, the debt coverage ratio is almost like a customer ratio. It helps you understand the quality of the customer.
Having a higher debt coverage ratio means you have a lower quality customer. But always keep in mind that the bank will lend you money if your numbers pencil out at a 1.2 debt coverage ratio. I know there are tons of gurus out there that teach 1.2. I'm telling you right now, don't fall for it. Don't buy a C class property with a 1.2 debt coverage ratio. And folks, this is a professional and personal experience talking. I've done it. I've made the numbers work, I got the bank loan, and I couldn't sleep at night.