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The Complete Debt Relief Manual Summary


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Debt Service

The next step in preparing the setup is to take explicitly into account the method of financing and associated annual costs. Debt service payments may include annual payments on a variety of debt instruments, including mortgage loans, ground leases, master leases, leasehold mortgages, and deeds of trust. Subtracting these debt service payments from the Free and Clear income yields the net cash available for the property owners, called Cash Flow After Financing (CFAF). For constant payment mortgage loans, interest is not the only factor affecting debt service outlays. For any given interest rate, the longer the term of the loan, the lower will be the required constant payment. Thus the effect of the government guarantee of home mortgages after World War II was to allow lenders at no risk to stretch out the term of the typical mortgage loan. Home-buyers could then buy more expensive houses for the same monthly payments. The table on page 35 illustrates the point.

Twenty Four Good Reasons to Buy Options Instead of Properties

I am willing to bet anyone an ice cold case of Beck's Beer that the numerous commercial real estate market meltdowns that have occurred during the past 30 years would not have been so severe if the high rollers had bought more real estate options instead of properties. In this way, if they did not want to exercise their real estate options, they could have simply let them expire, and that would have been the end of it. And they would not have incurred any of the transaction, maintenance, management, holding, and debt service costs that eventually forced them to go belly-up. In other words, they would not have been saddled with the financial responsibility and personal liability that go along with outright property ownership, and they automatically would have avoided having to

Six Costs That Eat Up Profits When Flipping Properties

The truth of the matter is that investors have no real control over how much a property-flipping transaction will ultimately cost them. The reason for this lack of cost control is that the actual amount of the holding cost is unknown when flipping a property. Holding costs include debt service, insurance, property taxes, maintenance, and security. And the single largest cost of holding on to a piece of property is its debt service or monthly loan payments. The problem with being the proud owner of a piece of investment property is that the mortgage meter is always running, whether the property is occupied or vacant. I learned this lesson the hard way when a property-flipping deal, which I thought was going to be a slam-dunk, turned out to be an air ball instead. When I was young and dumb, I bought a run-down single-family house in South Tampa with

Capacity Monthly Income

In terms of rental property income and expenses, lenders may apply a debt coverage ratio (DcR). A debt coverage ratio shows the lender that the property produces enough income to cover expenses and debt service (principal and interest). Here's an example of DCR for a fourplex whose units each rent for 750 a month If a lender wants to see a 25 percent safety margin of income over debt service, calculate your maximum allowable mortgage payment by dividing the property's annual NOI by a debt coverage ratio (DCR) of 1.25 NOI Debt Service 24,280 19,424

Use Fixed Rate Low Interest Lines of Unsecured Credit to Buy Options

Currently use two 40,000 lines of unsecured credit, which have fixed-interest rates of between 3.4 percent and 4.5 percent. I am able to obtain these low-rate lines of unsecured credit because I have zero consumer debt and a credit score in the top 5 percent. The real beauty in using unsecured lines of credit, instead of secured credit lines such as a home equity line of credit (HELOC), is that you do not have to put your home on the line and pay those exorbitant closing costs that lenders generally charge borrowers for the privilege of doing business with them. In fact, the most that I have ever had to pay when using an unsecured line of credit was a 50 transfer fee.

Investment Features Affecting Valuation

Leverage Most directly owned real estate is purchased with a down payment, often 30 percent or more for investment properties. The balance is financed. In this situation, an investor leverages the cash investment, controlling 100 percent with only 30 percent down. While many consider this a distinct advantage, notably when market values rise quickly, it is also a higher risk. The investor depends on consistent cash flow as a requirement for keeping up with debt service. A one-month vacancy may be serious, and a two- or three-month vacancy fatal if the investor has no cushion to make it through extended vacancy periods.

Decrease or Increase Your Down Payment

489.9285 X 7.39 X 12 43,446 (Debt service) less 43,446 (Debt service) 3,675 (BTCF) 459.928 X 5.85 X 12 32,287 (Debt service) less 32,287 (Debt service) 14,834 (BTCF) 538.526 X 7.39 X 12 47,756 (Debt service) less 47,756 (Annual debt service) -635 (BTCF) 471.210 X 7.39 X 12 41,786 (Debt service) less 41,786 (Annual debt service) 5,335 (BTCF)

Buy at a Bargain Price

Return to the eight-unit example that was valued with an 8.5 percent cap rate at 544,365. With the hypothetical baseline bank financing of 20 percent down and 7.5 percent, 25-year terms, the property produced a first-year cash flow of 8,502. But what if you could buy that property (or a similar one) at a bargain price (say 10 percent under market) You would pay 489,928.50, put 97,935.70 down, and borrow 391,942.80 (80 percent). Your annual debt service would fall to 34,757, and your cash flow (BTCF) would increase to 11,539 391.943 X 7.39 X 12 34,757 (Debt service) less 34,757 (Debt service) 12,364 (BTCF)

After Tax Return on Equity

For income property, a frequently used break-even calculation is to determine what percentage occupancy will be required to cover base levels of operating expenses and debt service. This is calculated as follows In this equation, Total Required Income is the sum of operating expenses, real estate taxes, and debt service payments. Break-even calculations are particularly useful in assessing the likelihood of achieving certain milestones and relating the investment to possible consequences of failure. For example, in the rental apartment development discussed above, an increase in debt service constant payments will also increase the break-even occupancy, and therefore the risk of operating at a deficit. Thus, in the case of the highest interest rates, the owner must not only accept a lower cash return on equity, but also must accept increased risk.

Should You Pay Off the Mortgage

If, on the other hand, he used the 12,000 cash to buy more property, then he could easily have bought four more (based on the same loan-value ratio of 25 percent as with the initial properties in 1960). Thus, his 12,000 could buy him another four properties, adding 36,000 of mortgage debt to his existing 12,000. By today, he would have 2 million of property, and only 48,000 of debt.

Estimating Cash Flows after Year

The cash flows and ratios calculated for year 1 give the investor a nice snapshot of how the property is expected to perform in year 1 of the holding period. The investor's time horizon is typically greater than one year. This is particularly the result of the high transaction costs associated with buying and selling real property. It is hard to recoup the commission expense associated with selling investment property after owning it for only a single year. Also, while the ratios we calculated are very useful for comparing properties, they are missing some important elements of the cash flows that the investor is to receive. Let's look at the ROI, and we'll see what information is lacking from this ratio. The ratio itself, as stated in Equation 11.10, is ROI NOI investment. This means that all the cash flow values that come below NOI are left out of consideration. Look at Tables 11.1 and 11.2 to see what information doesn't work itself into the ROI. The impact of financing is missing,...

Examining the borrowers ability to pay

For example, a lender may say that a buyer can afford to pay 28 percent of total gross income in mortgage payments (principal, interest, taxes, and insurance expenses). This percentage is called the front-end ratio. The lender also establishes that the borrower's total monthly debt payments, including PITI, can't be greater than 36 percent of the borrower's total gross income. This percentage is called the back-end ratio. 34,560 - 12 (months) 2,880 maximum total monthly debt payments including PITI Together, the front-end and back-end ratios work in such a way that the borrower's PITI and total debts have to fall below both criteria. So if in the example the borrower's total monthly long-term (usually 12 months or more like credit cards and car payments) debt payments without PITI were 2,000 a month, the lender would enable the borrower to spend 880 or less on PITI. On the other hand, if the borrower has no other debt, the lender still wouldn't enable the borrower to spend more than...

Capital For Real Estate Investments

Real estate investments are financed through a combination of debt and equity capital. The use of debt, or borrowed money, is very important in real estate, and a substantial majority of the new capital flowing into real estate is normally in this form. By year-end 1987, U.S. properties were supporting about 2.75 trillion in mortgage debt. The balance of the property value, of course, represents the owner's equity capital.

Who owes whom Assumption and assignment

A mortgage assumption takes place when a new party takes over the obligations of another person's mortgage debt, and it usually requires the approval of the lender. A typical situation in which someone may assume a mortgage is when a buyer buys a house from a seller who has a mortgage loan at a much lower interest rate than is currently available to the buyer. The buyer pays the seller the difference between the sale price and the outstanding balance of the seller's mortgage (which the buyer is assuming) either in cash or with a new mortgage. By assuming the old mortgage, the buyer also agrees to take over the payments on the remaining balance due. i If a property is purchased with the buyer assuming the mortgage, the buyer becomes personally liable for the portion of the debt not covered by the foreclosure sale. Say I buy a house for 200,000 paying the seller 100,000 cash and assuming a mortgage on which there is 100,000 left to pay. I lose my job, can't pay my mortgage, and to make...

Now Do the Simple Numbers

Write these numbers ( 90,000 mortgage 1,000)( 7.72) 694.80. This is your monthly debt service payment on your first mortgage. 5. Add the amount from Step 2 to the amount from Step 4. Thus, 694.80 + 222.40 917.20. This is your monthly debt service for the first 5 years you own this property.

In accordance with the promissory note signed by the borrower

Figure your Net Operating Income BEFORE debt service by subtracting from your Annual Income ( 80,000 for this building) the Annual Expenses ( 41,000 for this property). Thus, 80,000 - 41,000 39,000. 4. Figure your Annual P&I Debt Service Cost. For this building, it is 28,000 per year. 5. Figure your Debt Coverage Ratio by dividing your Net Operating Income by your Annual Debt Service Cost. Or, 39,000 28,000 1.39. This is your Debt Coverage Ratio.

Quickly Figure Your Capitalization Rate

Your last easy number for your real estate millions is the Capitalization Rate. This number tells you your percent return on your income BEFORE your P&I debt payments, based on the price you paid for the property. To figure your Capitalization Rate, divide your Annual Operating Income BEFORE Debt Service by what you pay for the property. Thus, if you paid 480,000 for the property discussed above, your Capitalization Rate 39,000 480,000 0.08. Or, multiplying by 100, your Cap Rate 8 percent.

Plenty of room Rentals on property

Most investors get returns on their investments by means of rents paid on the property. All expenses, including the mortgage loan payment, are paid from the rent and whatever else (such as quarters from laundry machines) factors into the building income. Investors call the mortgage payment debt service. The money left over after all expenses are paid, except debt service, is called the net operating income. After debt service is subtracted from net operating income, what's left is called cash flow, or the money the investment has earned before taxes. Check out the following two-part equation Part 1 Building income - operating expenses net operating income Part 2 Net operating income - debt service cash flow

Letting someone else pay off the mortgage Equity buildup

The mortgage payment, or debt service, always is included in the expenses of any investment property. If the borrower borrows money with an amortized mortgage, every payment made on that loan is part interest and part principal. (That's what amortized means.) So every time the building's income (in the form of rents and other income) is used to make a mortgage payment, usually monthly, the overall mortgage debt is reduced.

By the Numbers Analyzing Investment Properties

The beginning of a real estate investment analysis is the operating statement, which also is called the income and expense statement. This statement, which usually is prepared to keep track of finances for the building and for income tax purposes, tracks the actual annual income and expenses for a building. The income tracked on the operating statement is called the contract or scheduled rent, which is the actual rent paid by the tenants. Because the operating statement is used for income tax purposes, it usually contains information about depreciation and debt service (mortgage payments). I discuss depreciation in Feeling worn-out Depreciation, earlier in this chapter. Depreciation and debt service aren't accounted for. The value of the depreciation may vary with the owner's financial position, and the mortgage is more about the owner's financial position than the value of the building. Operating expenses Don't include depreciation or debt service Debt service Refers to the mortgage...

Review Questions and Answers

Don't get confused here with the term capital gains. Essentially, capital gains and capital appreciation refer to the same thing however, capital appreciation describes what the question is asking and capital gains usually describes the same thing for income tax purposes. Return of investment is the return of your original investment money (capital), not any additional money you make, which would be return on the investment. Cash flow is the general term used for the annual return on the investment after all expenses, including debt service, are paid. It's not important for this question, but cash flow can be referred to as before tax cash flow or after tax cash flow. Nothing in this question refers to taxes, so you can eliminate tax credit right away. (D) debt service. Correct answer (C). You'll have to remember this. Debt service and depreciation are not used because they are more specific to the property owner than the property itself. Remember that scheduled...

Assisting the Tenant in Finding a Mortgage

There are three basic factors a lender looks at when qualifying someone for a loan credit, income and debt ratio. 1. CREDIT 3. DEBT RATIO The debt ratio looks at how much debt a person has compared to his income. A credit report that shows high credit card balances, car payments and other obligations will seriously affect the tenant's ability to obtain a loan.

The Five Main Reasons Many Rental Properties Become Mismanaged

Lack of knowledge about the local rental market, which results in rental units being rented at below-market rental rates This produces a breakeven cash flow, which is barely enough to pay for maintenance and debt service when the property is at 100 percent occupancy. Any vacancy causes cash flow problems that must be covered by the property owner. 3. Failure to respond to tenants' routine maintenance requests in a timely manner This causes tenant turnover and vacancies, which increases the negative cash flow that the owner must subsidize in order to maintain the property and pay the debt service.

Breakeven Occupancy Rate

The breakeven occupancy rate is the occupancy level at which the property's income will just cover the bills. The bills that must be covered are the debt service and the operating expenses. The ratio appears in Equation 11.8. This tells the investor that the building needs a vacancy rate of 14 or less in order for the before-tax cash flow to be positive because if the vacancy is greater than 14 , the investor won't have enough NOI to cover the debt service and the operating expense. There is no magic number for breakeven occupancy however, the lower this ratio is, the sooner the bills will be covered and the higher the vacancy rate that the building will be able to absorb.


The maximum amount that FNMC would provide could be calculated by adding Jeff and Maiy's personal income to the income they planned to receive from rentals, then allocating 28 of that against the total of mortgage debt service payments, real estate taxes and real estate insurance. Furthermore, the bank's appraiser would have to examine the property and satisfy himself that the combined value of the property and any renovations proposed would be 125 of the loan amount. These criteria were quite firm, since most mortgage notes were re-sold by the lender in a secondary market or to Fannie Mae, the Federal National Mortgage Association. These secondary buyers could not, obviously, ascertain the soundness of the notes they bought in bulk unless the primary lender applied a stringent and consistent screening to each individual note.

Valuable Resources

The appraiser may begin by questioning whether current net operating income will be strong enough to cover debt service on a mortgage loan. To determine this, the debt coverage ratio is used. To calculate, net operating income is divided by the amount of debt service to calculate the ratio. For example, when net operating income is 52,800 and annual debt service is 37,896, the debt coverage ratio is This ratio provides a view of the net cash flow after expenses and debt service have been paid. How this compares to similar properties may reveal the relative strength of that cash flow and could affect the appraiser's conclusions concerning value.

Return on Equity

Cash Flow After financing is the Free and Clear Income less debt service payments Equity Investment is the Asset Cost less the amount borrowed. The Return on Equity is also called the Cash-on-Cash return. Because it measures a return on actual net cash invested, many developers and investors regard this as the most important return measure. This measure should be used with caution, however, because the returns are leveraged.

Two More Drawbacks

Sadly, 60 to 90 days pass, and the overpriced property doesn't sell. The owners panic. The lawyers are closing in for the kill. But now the listing is stale. To really grab buyer attention requires a severe price cut to maybe 275,000. By this time, though, the unpaid mortgage balance along with missed payments and late fees may total around 300,000. There's no way a sale will clear out the mortgage debt and the sales commission. More often than not, the foreclosure sale date rushes closer like a speeding freight train.

Credit Check

Vidual, and that is what you, as a landlord, should consider as well. If the credit report shows a history of late payments or, worse, defaults, there is no reason to believe that you, as a creditor, will be treated any differently. In addition, if the applicant has a high amount of debt, his or her income to debt ratio may not allow the applicant to become further leveraged. In this case, that would be the monthly debt to you in the form of rent. The reporting company takes these and the other aspects of a person's credit history and calculates a score.

Before Tax Cash Flow

The before-tax cash flow is where financing charges come into play. The annual debt service is the monthly mortgage payment times 12 plus any other financing payments such as contract for deed (land contract) payments. This annual debt service is deducted from the property's NOI resulting in the before-tax cash flow (BTCF). This is, in effect, the amount of money that is left in the checkbook after all the rents have been deposited and after all the expenses and the lender have been paid.

Example 111

Next we have to calculate the monthly mortgage payment, and then we'll multiply that by 12 to get the annual debt service. The mortgage amount is 835,500 x 0.80 668,400. The annual debt service is then 5,182.10 x 12 62,185.18. The before-tax cash flow from operations becomes Equation 11.4.

The escrow closer

Underwriters check to make sure that a loan meets guidelines for debt ratio, loan-to-value ratio, credit score, employment history, and other qualifications. They also evaluate the loan based on whether they can be bundled with others in a big loan package that can be sold to Fannie Mae, Freddie Mac, or another entity that buys mortgages.

Private Individuals

Most loan funds are from personal or business savings. Some loan arrangers have sought investors owning homes who had very low debt-to-equity ratios as well as those having debt free residences. By refinancing, they are often able to borrow at a much lower interest rate than they can loan their money at. They are thus able to make money on this interest differential by trading on their equity. Even if their loans are well secured, the investor in such a situation is placed at risk. Should the lien that they hold go into default, they may not have the funds to make their own mortgage payments, which would place their home at risk of foreclosure.

Year 2 Cash Flows

As indicated above, the PGI for year 1 is multiplied by 1.03 (3 growth) to obtain the year 2 value of 130,707. The vacancy in year 2 is once again the PGI times the 7 vacancy rate, resulting in a vacancy allowance of 9,149. That value deducted from the PGI leaves an EGI of 121,558 in year 2. Multiplying the first year's operating expenses by 1.02 (1 + 2 growth) results in operating expenses in year 2 of 47,940, and that value deducted from the EGI leaves an NOI of 73,618. The debt service is constant since we are using a fixed-rate constant payment mortgage, so the 62,185 deducted from the NOI leaves a BTCF of 11,432 for year 2. If we now take the principal balance at the end of year 1 minus the principal balance at the end of year 2, that will give us the principal reduction in year 2. The total debt service for the year (which is p + i) minus the principal reduction for the year will give us the total interest paid in year 2.


To accomplish this, we go back to Table 11.4 and take out anything that has to do with the mortgage. The debt service will go to zero as will the interest expense. The new amounts appear in Table 11.11. The cash flow from sale calculation from Table 11.5 is also affected, and those new values appear in Table 11.11. You will notice that the before-tax cash flows from operations are approximately 62,000 greater than the before-tax cash flows from Table 11.4. They are greater by the amount of the annual debt service payment that is not being paid in Table 11.10 because we are now free from debt. The after-tax cash flows in Table 11.4 are not greater than those in Table 11.10 by the exact amount of the debt service payment. This is because by using all cash, we have lost the tax benefit of the interest expense deduction. As a result the after-tax cash flows in Table 11.10 are greater by 49,000- 50,000.


A common type of loan for the real estate investor or business owner is a stated income loan. This type of loan does not require income verification. Lenders consider the lack of verifiable income to be added risk. The lender will calculate a qualifying debt ratio based on the income that the borrower states on the application. Verification of the source of income is required. Not all stated income loans are eligible to wage earners. Many lenders want stated income borrowers to be self-employed for two years and provide a letter from their CPA confirming this.You can be self-employed simply by filing a Schedule C for two consecutive years. The Schedule C does not need to show income.

Financial Analysis

Lending institution to lend money to a desirable project with the interest being exempt from Federal income tax. This had the effect of reducing the interest rate by several points, or to around 8 . Prudence returned to her setup, punched her calculator again in an optimistic frame of mind, and calculated a constant of 8.81 . After all, she had been told that most other parties to a real estate deal will take a pessimistic view of the proposer's projections so she might as well be positive. She knew that obtaining tax-exempt financing would take time, but might be possible for a rehabilitation of the Masonic Hall. Prudence also hoped she could justify a larger loan, perhaps 1.5 million, which would reduce the need to raise other funds. If tax-exempt, the debt service on this loan would be 132,077.62 per year. She continued with her cash flow to compute a stabilized cash flow after financing. Debt Service (80 )

Debt Coverage Ratio

The first of these ratios is called the debt coverage ratio (DCR). This ratio is of great concern to the lender who is providing the mortgage money for the transaction. This ratio tells the investor and the lender whether the NOI is adequate to cover the annual debt service. The ratio is the NOI divided by the annual debt service. The lender will typically want this ratio to be at least 1.2. In the case of riskier investments, such as new construction, the lender may want the DCR to be at least 1.25. You may ask why new construction would be riskier than an existing building. It is considered riskier because we start out with no tenants, and we don't know for sure when it will be fully occupied. The lender will want a larger cushion to cover any shortfalls in rent that may occur. When we present this investment plan to a financial institution, it would probably decline our mortgage application given the low DCR in this example. We can look closely at Table 11.1 and try to determine...

Organizing Your Debt

Organizing Your Debt

Whether you are married or single, taking charge of your overall finances may feel like a part-time job. Some easy ideas can help you streamline your time, organize your finances, and reduce the stress of debt and overall money matters.

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