Reduce Risk and Increase Investing Success

Reducing risk or exposure when investing can save you from future financial headaches and keep you from becoming that owner who is suddenly motivated to sell. Looking at the mortgage or note instrument used in connection with the real estate investment can help you determine if your purchase is a good buy. Ratios are good indicators that can help you determine if your purchase decision is a stop or a go.

You have found a property that looks like it might be a possible good investment. The home is in fairly good condition and is located in a neighborhood that is stable to increasing. You have discovered that after speaking to the owner, the first loan is $30,000 and the second loan is $10,000. The owner is asking $70,000 but your rough estimate (after doing your homework) is closer to $60,000 with the home in its present condition.

The Total Loans-to-Value Ratio

The total loans to value ratio is derived by dividing the total amount of loans by the estimated value of the property. The loan to value ratio for our property is $40,000/$60,000 = 67%. The percentage of loans relative to the estimated value of the property should always be less than 75%. Even if you are purchasing in a fast moving market, the percentage should not exceed 85%. By not exceeding the 85% rule you give yourself a cushion and better chance of reducing your risk.

The Equity-to-Debt Ratio 

Dividing the equity in the property by the total amount of debt yields this important ratio. The equity in our property is $60,000- $40,000 = $20,000. The Equity to Debt Ratio is $20,000/$40,000 = 50%. The general consensus is, the higher the ratio, the more secure the financial position. Mortgages with an equity to debt ratio lower than 25% percentage means you will likely have to hold the property for a longer term to wait for your equity to increase to recapture a profit.

 The Discount-to-Debt Ratio

In our example, the seller is further willing to discount his second mortgage of $10,000 to $7,000 if he can receive cash. The discount to debt ratio is used to measure mortgage risk and is found by dividing the amount discounted by the equity or $3,000/$20,000 = 15%. This percentage represents the cost necessary to bring the underlying loan, in this case, the second mortgage current if it should ever go into default. Mortgages are not always discounted but when they are, a ratio of more than 15%, indicates that your loan is in a good position and is “covered” at least on paper anyway.

If all three ratios meet your criteria – low debt, high equity and mortgage risk covered, then you may want to proceed. But before you do, make sure your real estate has the right location. Ask yourself, would I like to own this property? Would I live here? If not, why? Are there any features you absolutely do not like? Too close to a busy road? Low lying area- possibly flood prone? Too close to commercial plant or constant noise? Don’t select properties that are good deals but may be hard to sell or you may have to discount your asking price heavily because of adverse location factors which in some cases may be incurable.