Many people try to avoid debt. Having a low debt-to-income ratio is a sound strategy when it comes to personal finance. But not all debt is created equal.
Savvy real estate investors use debt with equity to own property without tying up their money. A good debt-to-equity ratio helps balance risk and increase the potential return on a rental property.
So, what is the debt-to-equity ratio? Use this as a guide to better understand the debt-to-equity ratio. Then, work with your real estate agent and financial advisor to determine if an investment property is right for you.
Key Takeaways:
- Debt-to-equity ratio is a metric used to measure how much debt an investment property has relative to its equity.
- Debt-to-equity ratio is calculated by dividing the mortgage balance by the property’s equity.
- Generally, a higher debt-to-equity ratio represents a greater financial risk, and a lower ratio represents a lower financial risk.
- Increasing debt-to-equity can be a smart investment strategy when refinancing a property.
What is debt?
Before diving into the debt-to-equity ratio, it’s important to level-set a few key concepts. The first is debt.
In finance, debt is the total of all money owed to a lender. Most people have multiple debt sources ranging from student loans to credit cards and care notes to mortgages.
In real estate, debt refers to the amount of money an investor or property owner owes a lender for a property. It’s the amount owed on the property’s mortgage.
What is equity?
The second concept is equity.
According toInvestopedia, equity is “total assets minus total liabilities in finance.” It represents the amount of money an individual or shareholder would get if the asset was liquidated and all debts were paid off.
In real estate, equity is the difference between a property’s value and total liabilities. When you purchase a property, the equity is typically equivalent to the down payment. The property’s equity increases as you pay off the mortgage, and the property value increases.
Debt-to-income ratio vs debt-to-equity ratio
Many new real estate investors confuse debt-to-equity ratio with debt-to-income ratio. And it’s easy to see why. The terms have very similar names and measure financial health but are very different.
In personal finance,the debt-to-income (DTI) ratiois what’s typically used by lenders to determine a borrower’s ability to repay the money a loan. It’s calculated by adding up their total debt and dividing it by their gross monthly income.
In real estate, the debt-to-equity ratio is a metric used to measure how much debt an investment property has relative to its equity.
For real estate investors, the debt-to-equity ratio measures the risk associated with a potential investment property.
What is debt-to-equity ratio?
In business, the debt-to-equity ratio is “used to evaluate a company’s financial leverage and is calculated by dividing a company’s debt by its total shareholders’ equity,” according toInvestopedia. It measures the degree a company is financing operations with debt versus profit or other resources.
In real estate, debt-to-equity measures how much long-term debt a property has relative to its equity and is usually reported on its balance sheet. It’s also a way of measuring how much of a property an investor owns.
How is debt-to-equity calculated?
The debt-to-equity ratio is calculated as the total amount of debt divided by the total amount of equity.
Debt-to-Equity Ratio = Mortgage Balance / Equity
Here’s how it works.
Let’s say you purchased an investment property with $500,000 in debt and $250,000 in equity. $500,000 divided by $250,000 equals 2. The debt-to-equity ratio is 2, which means you owe $2 for every $1 owned in the property.
What’s a good debt-to-equity ratio?
A good debt-to-equity ratio is at a minimum of 70% debt and 30% equity, or 2.33.
Most experts advise not to invest in a property with a debt-to-equity ratio of 5.5 or higher. The reason? A higher debt-to-equity ratio means greater financial risk to investors because the property’s debt far exceeds its equity. And mortgage lenders are less likely to issue a loan because borrowers are more likely to default.
Investors should look for properties with a lower debt-to-equity ratio because the financial risk is lower. However, this isn’t a hard and fast rule.
Let’s take a closer look at what high and low debt-to-equity ratios means for investors.
High debt-to-equity ratio
In simple terms, a high debt-to-equity ratio indicates high risk.
Here’s an example.
Let’s say you own a triplex with a high interest rate that carries $600,000 in debt and $100,000 in equity. The debt-to-equity ratio is 6. You can make the monthly mortgage payments, but there’s an economic downturn, and a tenant moves out. It’s a few months before you can lease to another qualified tenant. Will you be able to afford the mortgage payment without them?
Some investors prefer to invest in properties with higher debt-to-equity ratios because they have the potential to yield higher returns.
Always talk to your financial advisor and mortgage lender before investing in a property. They’ll help you determine which strategy is best for you.
Low debt-to-equity ratio
A property with a low debt-to-equity ratio represents less financial risk.
Here’s an example.
Let’s say you own a single-family rental property with $250,000 in debt and $100,000 in equity. The debt-to-equity ratio is 2.5. There’s an economic downturn, and your tenant moves out. You’re more likely able to afford the mortgage on this property than the one in the first example.
Properties with lower debt-to-equity ratios are typically more stable but yield lower investment returns.
Talk to your financial investor before investing in real estate. They’ll help you identify the ideal ratio for your financial situation and goals.
Does debt-to-equity ratio change over time?
Yes. It can decrease or increase depending on several factors. These include paying down the mortgage loan and changes in property value.
Here’s an example of how a debt-to-equity ratio can decrease over time.
Suppose you invest in a rental property that cost $200,000 three years ago. You’ve now paid down the mortgage to$120,000. Moreover, the property value has increased by 30% and is now valued at $260,000.
Purchase price: $200,000
Current property value: $260,000
Mortgage balance: $120,000
Equity: $140,000
Debt-to-equity ratio: .85
In other words, you owe just $0.85 for every $1 owned in the property.
Here’s an example of how the debt-to-equity ratio can increase over time.
Suppose you invest in a rental property that cost $200,000 three years ago. You paid the mortgage but had to take out ahome equity line of creditto pay for unexpected repairs. What’s more, the local real estate market has taken a downturn. The property is now valued at just $175,000.
Purchase price: $200,000
Current property value: $175,000
Mortgage balance: $170,000
Equity: $5,000
Debt-to-equity ratio: 34
This means you now owe $34 for every $1 owned in the property.
Increasing debt-to-equity ratio as an investment strategy
A higher debt-to-equity ratio indeed poses more significant financial risks to investors. But, sometimes, it can be a good investment strategy. Like when you want to do a cash-out refinance.
According toBankrate, “Cash-out refinancing replaces your current home loan with a bigger mortgage, allowing you to take advantage of the equity you’ve built up in your home and access the difference between the two mortgages (your current one and the new one) in cash.”
Here’s how it works.
Let’s say you own a single-family rental property valued at $200,000. It generates $10,000 in cash flow per year. The mortgage balance is $100,000, and the equity is $100,000. The debt-to-equity ratio is 1. The return on equity (calculated by dividing cash flow by equity) is 10%.
You want to do a cash-out refinance to use the equity to purchase another rental property.
The mortgage on your new mortgage balance increases to $150,000 with $50,000 in equity. The debt-to-equity ratio is now 3, and the cash flow is $8,000 because of the increased mortgage payments. But the return on equity increased to 16%.
Talk to your financial advisor or mortgage lender before taking a cash-out refinance. They’ll help you assess the risks and benefits to determine if it’s the right strategy for you.
The bottom line
Savvy real estate investors know how to use debt (other people’s money) to work for them. The debt-to-equity ratio helps them assess risk. Some investors have a higher risk tolerance and don’t mind having a higher debt-to-equity ratio. Other investors prefer a more conservative approach. Talk to your financial investor before deciding which strategy is best for you.
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