Leverage Ratios In Action

Real estate investors use leverage, otherwise known as borrowed money, in order to fund their investments in hopes of producing higher returns.

Leverage ratios can reveal how well that borrowed money is working for a particular investment. These types of financial ratios show an investor’s debt against their income and can provide insight into the investor’s long term financial health. This can be very helpful for certain real estate professionals, primarily lenders, who can use leverage ratios to determine how much they are willing to lend and evaluate the investor’s ability to pay back debt.

There are several different types of leverage ratios that show varying information. Depending on who is performing the analysis and what information they are looking for will determine which type of ratio is used. Let’s take a look at some of the more common leverage ratios used by investors and lenders.

Debt-to-assets ratio - This ratio shows how much of your real estate investments, or assets, are financed. In order to be considered low-risk and more easily secure financing you will want your debt-to-asset ratio to be 0.5 or less. Ideally you want your portfolio to show that you have more assets than liability.

Debt-to-equity ratio - This ratio uses total equity rather than total assets to determine whether an investor is financing the majority of their projects using debt or equity. A sum of 2 using this calculation is often considered risky, so it is best to keep your debt-to-equity ratio between 1 and 1.5.

Debt-to-capital ratio - This ratio is calculated by dividing the total debt by the sum of total debt and total equity. This is typically used by investors to determine risk in a partnership deal. If the debt-to-capital ratio is more than 1, the debt surpasses the capital, meaning there is greater risk.

Asset-to-equity ratio - This ratio measures the total assets against your equity. A high ratio in this category means high debt and lenders will likely decline additional financing.

While there are a number of examples where leverage ratios might be put into action, there are two very common situations where leverage ratios are used to aid specifically in real estate transactions. Typically these calculations are made by lenders in order to determine the loan amount or whether or not to provide financing at all.

Cost Vs Value - Leverage ratios are used by lenders when an individual purchases a property where the cost is different from the actual value. The lender will want to ensure they are not exceeding a certain ratio compared to the value when issuing a loan.

Refinancing - Leverage ratios are often used when refinancing a loan. Typically at the time of a refinance, cost is not taken into account. The lender is focused on the value and equity when deciding the terms for the refinance.

It is beneficial to understand leverage ratios and how high and low ratios can impact your loan terms. While leverage ratios are an important tool, they are not the only thing considered by a lender when obtaining financing and many private lenders will take on more risk than traditional institutions, so be sure to find the right lender for you!

If you are in need of financing for your next investment project, allow CALCAP Lending to be your resource in finding a loan that works for you!