How to High-Level Investors Evaluate the Financing Side of a Rental Property Deal

You’ve spent weeks researching, and you’ve finally found a property in a good location with good schools and a steady renter demand. It looks like decent appreciation down the road, and, on paper, it seems like a slam dunk.

If you’re an experienced investor, though, you know that no matter how great a property looks, it can still end up being a bad deal if the financing isn’t right.

The property you buy is important, of course, but so is the way you pay for it, and that’s not being said enough. Interest rates and the terms of your loan don’t affect just your monthly mortgage payment but also your cash flow and profits.

The same property can look profitable with one loan and be a money pit with another one.

That’s why you need to sit and carefully evaluate the numbers before you go any further.

The Numbers Behind the Loan

Think like a lender for a minute.

Would you just hand out money based on whether you like a person or not? No.

You’d want proof that the property can carry the debt, and this is where you’d want to see some numbers.

NOI (net operating income) is the first thing lenders want to see.

This is your rental income minus all the costs for operating, like property taxes, insurance, maintenance, and such. The loan payment is not a part of this, so keep that in mind. NOI shows if the property is earning enough income to support financing.

Then there’s debt service, which is your total annual loan payments, including principal and interest. There should be a nice cushion between your NOI and those payments. Lenders call this coverage ratio, and, put simply, it shows whether there’s still money left over once your loan is covered. If there’s not, then no deal for you.

Next is LTV, or loan-to-value ratio.

This compares how much money you’re borrowing to what the property is worth. In the end, you have the interest structure; fixed rate means predictable payments, variable rate means you might start lower, but nobody can guarantee that it won’t climb as time goes on.

Looking at Loan Options and Rate Conditions

Once you’ve run the numbers, it’s time to figure out which loan to choose. Financing is a very broad term, and the choice you make at this point can mean the difference between good returns and ruin.

So what do you do? Easy – compare different loan structures and lender terms before signing anything.

You’ve got options for rental properties, and probably the most basic one is a good ol’ conventional mortgage. This works great for some, but remember that portfolio loans or loans that are made specifically for income property are usually more flexible. Each option has its own rules to qualify, as well as trade-offs and repayment schedules, so look carefully at each of those.

Obviously, you can’t forget about interest rates because even a tiny difference in rate can change your monthly payment and the total cost of borrowing over time.

Make sure to shop around and compare lenders to get the best combination of rate and terms.

Some investors will even periodically check DSCR loan rates in Massachusetts, in Nevada, in New York, Alabama, California, Florida, etc. – in states where real estate is booming – and then compare those numbers to what’s happening on the market in their state.

The point is to be as informed as possible because that’s the only way to see if the loan option in front of you is competitive or if you need to look elsewhere.

Risks to Watch Out for

You should always be aware of things that might go wrong, not in a paranoid way, but in a way where you have some semblance of a plan B.

Here’s a quick example – interest rates:

They don’t necessarily stay the same, and if you’ve got an adjustable-rate loan and rates climb, you’re in a pickle because your monthly payment will go up. That’s why many investors stick with predictable financing.

There are other ways your cash flow can get squeezed, like an unexpected repair or an increase in property taxes. Besides, you can’t be 100% sure that your rental income will stay steady because tenants move out, markets shift, etc.

Build potential vacancies into your evaluations so you’re not blindsided if they happen.

Refinancing can be a good option down the road, but remember that credit markets don’t always play nice when you need them to. If you’ve already taken out too much debt across several properties, a downturn can leave you with hardly any room to maneuver.

Conclusion

When it comes to real estate deals, approach them like you would if you were buying a car.

You’d first peek under the hood, right? Well, it’s the same for this.

Look at the financial details of the deal before you decide to sign anything.

There’s no guarantee in life, but if you get this part right, the deal has a much, much better shot at working the way you want it to. So once you find a property with a great curb appeal, make sure that the financing underneath is just as pretty.