Debt to Asset Ratio Questions

13 Replies

Hey guys,

   Been looking around and trying to do some research on debt risk.   The only measurement I could find was debt to asset ratio.   I want to make sure as I take on buy and holds that I am not putting my family at risk.     I have decided to keep 4-5 months cash reserves for every property I own.  4-5 months for my own personal budget.     I however am not sure how much leverage is to much.   Is the debt to asset ratio a good metric for this.  Mine came in at .55    which I was told is a good place to be.      I understand the basics good debt vs bad argument.   I just want to make sure I don't take on too much debt.

@Gareth Fisher

Most people go bankrupt not because they have more liabilities than assets, but rather because they have more expenses than income. In other words, they may be worth millions but don't have enough income from those assets to pay their bills. That's why lenders tend to focus on debt to income vice debt to assets (net worth really). Make certain you are making enough cash flow to cover your expenses and then the reserves are for short term set backs, 4-5 months, until you can get your cash flow going again. Reserves will not help you for long if you suffer a permanent loss of cash flow.

@Edward B.     So if I'm understanding,  your reply correctly. I should be more concerned with my cash flow. or debt to income ratio then debt to asset.      If I look at just my 2 single family rentals.  My debt +taxes+insurance is around 1350.   The income is 2000.      Which gives me a debt to income ratio of .67  

From what I have read this is not a very good number.     Obv If I add in my personal income, but I don't see why I should since my rei business should pay for itself.

Cash flow from you're previous properties will be very important when applying for new loans. Some lenders can use that income to swing the DTI in your favor. I'm reading that .43 is an benchmark for the upper limit. If you're able to decrease the PITI that would help. 

@Gareth Fisher for investment properties and commercial loans, banks look at Debt Service Coverage Ratio (DSCR). Most banks will require at least a 1.2, meaning the income is 120% of PITI. At an income of $2000 and expense of $1350, you're just shy of 1.5, which is a very good ratio. if you stay at 1.4 or better, youre in good shape.

@Gareth Fisher , net worth (debt to assets) is what matters in the long run, cash flow (roughly debt to income) is what matters in the short run, day to day. You kind of have to balance the two but cash flow is the alligator closest to the boat. I would say focus on cash flow with an eye always on your net worth. 

I've found that expenses on SFRs tend to run in the 40%-60% range over the long term, that includes taxes and insurance but not principle and interest payments. So rough numbers, if your expenses are 50% then you have $1k to cover your debt service (PI) and anything left over is your cash flow.

Banks underwrite loans differently and determine your DTI differently, that's why it pays to shop around. Your actual DTI on your property is much higher than .67 because you have not factored in most of your expenses. How a bank looks at it will vary. Like you, I prefer to track my investment's performance independently from my personal finances, but banks will look at the whole picture.

Your only concerns about what banks think should extend no further than your desire to secure financing from them. Otherwise they are pretty much utterly clueless about REI, personal finance, etc. and the metrics they use are poor tools to determine your own financial health. That's why they will happily lend hundreds of thousands of dollars to a first time home buyer who can barely afford it with no track record of managing debt, but not to a real estate investor with a net worth of hundreds of thousands of dollars that weathered on of the worst real estate markets in the past century without a hiccup. IF you need/want their money you need to understand and position yourself to satisfy their metrics, but don't use them to determine how well you or your investments are performing.

@Edward B.   

  @Jason D.

Ok,  I believe I got all of that.  But From what I reading none of these metrics are all that good for measuring my personal finances.    

I have been reading a bunch about debt.  Good debt vs bad debt.    I wanted to find some metrics to assess my risk, my overall financial standings.     I have been tracking networth, have my accounts separated.    However I am unsure what tools I should be using to measure my overall performance.   

I know banks will loan to me, just not sure I want to assume more risk until I have a better understanding of the risk I am assuming.

@Gareth Fisher , what you are talking about really is a personal decision. How risk tolerant are you? What is your definition of risk? Your conservative may be my aggressive or vice versa. Maybe the best way is to figure out what keeps you up at night. Are you worried that you won't stay afloat if your income takes a hit or your expenses suddenly increase? Take measures to mitigate that such as reducing your personal DTI ratio or increasing your reserves.

You can certainly use many of the metrics that banks use to assess risk, or better yet that are used to evaluate the financial viability of a company. Those are not bad measurements of risk. Maintain your personal Income Statement, Balance Sheet, and Statement of Cashflows and then choose which metrics give you the best warm fuzzy. Free cash flow, quick ratio, debt ratio, etc, etc. I'm guessing that is not the answer you were looking for, but like I said it is very personal and there is not a one size fits all.

@Edward B. you're correct, but It ends up as the same formula, it will depend on the lender too. Different lenders look at NOI differently, such as including maintenance reserves as expenses.

SO If I want to mitigate risk I would counter this by increasing my cash reserves?  

Is there a metric for assessing risk?

Maybe I just used the banks formulas?  It's seems that they wouldn't loan me money, if they didn't think I could pay it back?

@Gareth Fisher reserves only serve as temporary relief. To lower your risk you have to increase your income or lower your expenses. Your risk is the ability to pay you debt, so buying good, cashflowing properties are the best way, in my opinion, to mitigate risk. You can use any formula you want to come up with a ratio, but I dont think there is any "standard" to measure yourself against, because it's a personal decision.

I agree with what others have stated. DTI and reserves are your most important indicators to hedge risk. The standards that banks have are based on statistical measures. The current standards are a pretty good benchmark (e.g., DTI < 43%, DSCR < 1.25, 6 months reserves, LTV < 75%). I try to stay in line with these benchmarks. Leverage is an awesome way to build wealth if managed correctly.

Free eBook from BiggerPockets!

Ultimate Beginner's Guide Book Cover

Join BiggerPockets and get The Ultimate Beginner's Guide to Real Estate Investing for FREE - read by more than 100,000 people - AND get exclusive real estate investing tips, tricks and techniques delivered straight to your inbox twice weekly!

  • Actionable advice for getting started,
  • Discover the 10 Most Lucrative Real Estate Niches,
  • Learn how to get started with or without money,
  • Explore Real-Life Strategies for Building Wealth,
  • And a LOT more.

We hate spam just as much as you