Real estate is an excellent investment strategy because of the historical appreciation, consistent cash flow, and the many tax breaks and benefits that owning an investment property allows. One of the more popular ones is the 1031 Exchange, a tax break that can help you defer your capital gains and keep your annual property tax bill low. Here’s everything you need to know about how the 1031 Exchange works.

What is the 1031 Exchange?

The 1031 Exchange is also known as the like-kind exchange or Starker exchange. It gets its name from Section 1031 of the Internal Revenue Code (IRC). The 1031 Exchange is a tax break that allows you to sell a business property or real estate held as an investment and swap it for a new one for the same purpose while deferring the capital gains tax on the sale. 

Or, to put it more simply, when you sell an investment property, the Internal Revenue Service (IRS) requires you to pay capital gains tax of up to 20%, depending on your taxpayer bracket, on the sale price. However, suppose you use the money from the sale of the original property (known as the relinquished property) to buy another (known as the replacement property) for the same purpose within a specified period. In that case, you can defer the capital gains until the replacement property is sold. 

There are a few exchange rules to consider when utilizing the 1031 process: 

• An exchange can only be made with like-kind properties, that is, two real estate assets of a similar nature as defined by the IRS. Both properties must be located in the U.S. to qualify.
• The replacement property must be of equal or greater value to the relinquished property.
• While the 1031 Exchange is most frequently used for buildings, it can also be used for raw land, a ranch, or strip malls.
• There is no limit on how frequently you can do a tax-deferred exchange. Theoretically, you can roll over gains from real estate investments indefinitely to new purchases, only paying a one-time final capital gains tax on the last sale.
• After selling your relinquished property, you have 45 days to find potential replacement properties. 
• A qualified exchange facilitator or intermediary must hold exchange funds in escrow until you purchase the replacement property. You have 180 days to close on the replacement property once you’ve sold your relinquished property.
• The 1031 provision cannot be used for your principal residence. 

When to use a 1031 Exchange

Savvy real estate investors use the 1031 Exchange process to defer capital gains tax and build wealth. However, you may choose to sell a property and utilize this tax break for several other reasons. These include:

• Investing in a property that has better returns, either in rental income or appreciation, than your current property.
• Exchanging a self-managed property for a managed unit or units. 
• Consolidate several properties into one for life estate planning purposes or simplifying assets.
• Selling one property and exchanging it for multiple units to diversify your real estate portfolio or to take advantage of numerous real estate markets.
• Turning your vacation home into a rental property.
• To reset the depreciation on your property. (More on this below.) 

Property requirements for a 1031 Exchange

Any property held for business or investment purposes can be exchanged for another as long as the IRS sees them as like-kind properties. The definition of like-kind is broader than it seems since it refers to the nature of the investment rather than the form. A single-family rental can, therefore, be exchanged for a multi-family apartment building. 

While you can exchange vacant land, you cannot trade partnership shares, notes, stocks, bonds, certificates of trust, properties in foreign countries, personal property, or stock in trade. For instance, if you purchase a house to flip and sell as soon as it’s been renovated, that will be considered “stock in trade” or business inventory and, therefore, ineligible for the 1031 Exchange. Similarly, if you sell too many properties during a year, you may be considered a “dealer” and the properties “stock in trade.” 

Let’s talk about some of the common types of property and the rules regarding the 1031 Exchange for each.

Vacation home

You cannot exchange a vacation home and expect to take advantage of the 1031 provision. However, if you convert that vacation home to a rental property, you’re good to go. To do this, you’d need to stop using your vacation home for personal trips, rent it out for a minimum of six months to a year, and then exchange it for a different property. This converts the vacation home to an investment property and, once classified as such, exchanges it for another investment property using the 1031 Exchange. It is crucial, however, that you have tenants in the vacation property to not be disqualified from the exchange.

Residence or second home

As already mentioned, a property that’s in personal use as a primary residence is disqualified from the 1031 Exchange. However, like with your vacation home, if you rent it out for a period of time, it can be converted into an investment property, changing its nature and making it eligible.

Tax implications of a 1031 Exchange

While using the 1031 Exchange is an excellent tax strategy. it is also one of the more complicated ones, which means you need to consider some income tax and estate implications; these include:

Partial sales proceeds

All 1031 exchanges happen through a qualified intermediary, a person or company that sells your property on your behalf, holds on to the money from the proceeds, purchases the replacement property, and ensures all transfers are done in keeping with IRS guidelines. A qualified intermediary must have 1031 exchange transactions to ensure that the sale is not taxed. 

After you purchase the replacement property, cash may be left over, which the intermediary must pay out to you at the end of 180 days. These partial sales proceeds from the property sale, known as “boot,” are taxed as capital gains.

Mortgages and loans

It’s essential to consider loans and mortgages while selling your property. Even if you don’t have any cash come back to you as partial sales proceeds, your debt may still be reduced on the replacement property. The difference will be treated as taxable income if that is the case.

Depreciation recapture

Over the life of a property, you will claim depreciation as a tax break; that is, a property’s everyday wear and tear is considered an expense. However, when you sell the same property, the depreciation accumulated during that time frame is “recaptured” and taxed. A 1031 Exchange allows you to avoid this recapture by rolling over the cost basis from the old property to the new one. It’s always best to talk to a qualified CPA for these calculations.

Estate planning

For long-term investors, one of the most significant benefits of the 1031 Exchange is estate planning. Tax liabilities end with death, so your heirs inherit the property at the stepped-up fair market value and are not required to pay capital gains tax. In the long-term, you could purchase a property for your family and end up not paying any capital gains tax on it. 

Type of exchanges

A few different types of exchanges are possible within the 1031 Exchange. These include:

• Delayed exchange: This is the most common type of exchange. You have 180 days to purchase a new property with the delayed exchange. If the relinquished property sells first, the funds are held by the qualified intermediary until the replacement property is acquired.
• Built-to-Suit exchange: This is also known as a construction exchange or an improvement exchange. This exchange allows the deferred tax dollars to be used towards renovations of the replacement property. These exchanges are still subject to the 180-day rule, which means all modifications to the replacement property must be finished within this time limit.
• Reverse exchange: A reverse exchange or forward exchange is when you purchase a replacement property before you’ve closed the sale of the relinquished property. When this happens, the property is transferred to an exchange accommodation titleholder, and a qualified exchange agreement must be signed. 

The BRRRR method is a real estate investing strategy that can be very lucrative for seasoned investors. But, like all investments, it’s not without risks.

If you’re considering a BRRRR strategy, this article is for you. Use it as a guide to help determine if the BRRRR method suits you.

What is the BRRRR method?

The BRRRR method is a real estate investing strategy. BRRRR is an acronym for Buy, Rehab, Rent, Refinance, Repeat.

Investors purchase properties that need renovations. They rehab them and rent them out. Then, after they’ve built up equity, they do a cash-out refinance to use their profit on another property.

The BRRRR strategy may seem like a form of house flipping, but it’s pretty different.

Like BRRRR, house flipping is a type of real estate investment strategy in which the investor buys a distressed property and rehabs it to add value. However, house flippers turn around and sell the property for its higher after-rehab value to earn a profit. BRRRR investors keep their properties to build equity. They use that equity to buy more properties.

The BRRRR method is a complex real estate investment strategy that requires a deep knowledge of the real estate industry and financing processes. As a result, it’s not a reasonable investment strategy for beginners.

The 5 steps of BRRRR

BRRRR stands for Buy, Rehab, Rent, Refinance, Repeat. They’re essentially the steps of the BRRRR strategy. Let’s take a closer look at them.

Buy

The key to success and profit using the BRRRR method is buying an investment property at a discounted price with a reasonable interest rate. Investors focus on distressed properties that most homebuyers don’t want. These properties typically need renovations and upgrades and are listed for below-average sales prices.

Once you’ve found a potential property, it’s essential to understand precisely how much work the property requires. Bring in experts to help determine rehab costs and timeline. Then factor in your down payment, closing costs, purchase price, interest rates, and mortgage payment. These will impact your bottom line, so it’s essential to do the math before you work with a lender to purchase your investment property.

You’ll also need to determine how you will finance your investment property. There are a couple of options available. They are conventional loans and hard money loans. Banks issue traditional loans. Private lenders give hard money loans. And both have their benefits and downsides.

Conventional loans meet Fannie Mae’s or Freddie Mac’s requirements. Before issuing a home loan, traditional lenders will review your credit score, debt-to-income ratio, and property valuation.

House flippers often use hard money loans because they’re faster to secure. Also, hard money lenders typically don’t require a credit check because the property is used as collateral. They also usually have higher interest rates than conventional loans.

Rehab

This is where you list all the items that need to be fixed on the property. Does it have structural issues? Is the kitchen dated? Does the floor plan work for modern families? Make a list of all the necessary and nice-to-have upgrades. Then, prioritize the list against your rehab budget. This will help you determine how much money you have and what you can accomplish.

Structural issues always need to be addressed. After that, investors typically focus on renovations and upgrades with the greatest return on investment. For single-family homes, this usually includes upgrading the kitchen and bathrooms.

An easy way to determine what renovations to make is to figure out the property’s after-repair value (ARV). ARV estimates the potential property value after renovations and upgrades have been made. This is the value added to the original purchase price.

For example, according to HGTV, minor kitchen remodels that cost around $15,000 have a 100% return on investment. That means it’d add $15,000 to the ARV. And adding square footage? Every 1,000 square feet added can increase the property’s value by 30%.

Rent

As soon as the rehab is complete, find renters. There are a few steps in this process. Here they are: 

1. Set a monthly rent: Make sure it covers your monthly mortgage payment plus a little extra. Why? If you decide to manage the property yourself, you’ll need positive cash flow to cover maintenance issues and property taxes. If you hire a property management company, you’ll need positive cash flow to pay them.
2. List the property: This critical step helps prospective renters find your rental.
3. Screen and find a qualified renter: This is important because it helps reduce your risk. Most property owners require a background and credit check before leasing their properties to renters.
4. Create and sign a lease agreement: A lease agreement is a contract that protects the landlord and tenant. It outlines crucial information like how long the renter can live at the property, whether pets are allowed, what the monthly rent is, and when it’s due. It also details how maintenance issues will be addressed and the eviction process should they be needed.
5. Collect rent: Timely rent payments are essential to generating passive income.
6. Manage the property: Being a landlord is an important job. Make sure your renters can contact you whenever an issue arises and that you address them promptly.

Refinance

The BRRRR investing method focuses on cash-out refinancing. Cash-out refinancing allows owners to access the property’s equity to withdraw money for any purpose. BRRRR investors typically use the cash to put towards another property.

Here’s how it works.

Let’s say you owe $75,000 on a home with an appraised value of $250,000, and you have $125,000 in home equity. BRRRR real estate investors liquidate the equity with a cash-out refinance loan and use it to purchase their next property.

Cash-out refinancing depends on equity, and building equity takes time.

After finding a qualified renter, BRRR investors wait until they’ve built up enough equity for a cash-out refinance.

It’s important to note that lenders have different seasoning periods, the amount of time a property must be owned, and requirements for cash-out refinancing. Keep this in mind when finding lenders for your BRRRR property.

Repeat

This is the step that can make the BRRRR method lucrative. Investors use the cash they got from the cash-out refinance to purchase their next property and start the process all over.

The pros and cons of the BRRRR method

Every real estate investment strategy comes with benefits and risks. The BRRRR method is no exception. Let’s take a closer look at the pros and cons of the BRRRR strategy.

3 pros of the BRRRR method

1. Earn passive income: BRRRR provides a repeatable framework for real estate investors to earn steady, passive income.
2. Build equity: Holding onto properties rather than selling them allows BRRRR investors to build equity continuously.
3. Repeatable process: It creates the potential for investors to build wealth exponentially.

3 cons of the BRRRR method

1. Not for beginners: The BRRRR strategy requires a lot of real estate knowledge and experience. Investors must accurately assess market values and rehab costs and manage budgets and timelines. It’s not for everyone.
2. Costs of rehab: Anyone who’s ever watched a house-flipping show on HGTV knows unexpected expenses always pop up, and the timeline always gets extended. It can be quite costly and stressful to rehab a property.
3. Property management: Being a landlord isn’t for everyone. It takes a lot of work to find renters and manage properties. The work only compounds as you add more rental properties to your real estate portfolio.

Is the BRRRR method right for you?

Well, it depends on your real estate industry knowledge and risk level. The BRRRR strategy has a lot of benefits and downsides.

BRRRR can be very lucrative for investors who can assess market conditions accurately, set budgets, and manage rehab timelines. However, it can be costly and takes time to realize the total return on investment.

Alternatives to the BRRRR method

Do you want to invest in real estate but are not sure if the BRRRR method suits you? That’s ok! There are plenty of alternative real estate investment strategies. Below are a few.

Short-term Rentals

Short-term, or vacation, rental properties are finished living spaces that are available to rent for short periods. They offer many benefits for real estate investors, including higher income potential.

Long-term Rentals

Long-term rental is a “traditional” rental property. The difference from a BRRRR property is that its one that’s move-in ready and able to generate passive income more quickly.

House Flipping

House flipping a real estate investment strategy where investors buy properties, fix them up, and sell them for a higher price.

Managing your finances and understanding your financial health can be a complex process. Still, as most of us want to live a debt-free lifestyle, we must know where we stand. And if you’re growing your wealth, such as through real estate investing, having a clear picture of your financial status is a must.

One of the most important metrics for understanding your financial status is something called a debt-to-income (DTI) ratio. Understanding your DTI is essential if you plan to buy real estate, as it’s a metric lenders include to determine if you are a financing candidate. DTI ratios allow you to quickly compare how much money you owe each month in personal loans with how much income you make. For your financial health, the lower the DTI ratio, the better.

This article will cover what DTI is, why it’s important, how to calculate it, and tips for improving it. 

Why DTI ratios are important

How firm is your financial footing? Can you save or invest each month, or does it feel like the monthly bills have gotten away from you?

The DTI ratio assesses your overall financial health, and if you can afford that big purchase you’re planning to make, whether it’s a new car or a second home. It’s a way to determine whether or not you are financially secure or need to take the necessary steps toward achieving your financial goals.

For homebuyers and real estate investors financing a real estate purchase, lenders use the DTI ratio to gauge your ability to manage monthly payments and repay the loan. The most attractive borrowers are those with enough income to meet their obligations. The last thing lenders want is to start expensive  foreclosure processings because the borrower can’t afford the payments on their property.

The various loan products have different DTI limits, so this calculation shows what financing you qualify for. Understanding your DTI before you seek a loan saves you time because it narrows down whom you can work with and what financing options best fit the purchase.

How to calculate your DTI ratio

The DTI calculation is relatively simple. To start, add up all your monthly bills to get the total amount you owe to creditors each month. Qualifying debt includes rent payments, auto loans, lines of credit, child support payments, alimony, student loan payments, and monthly credit card payments. They use your required minimum credit card payments if you don’t have outstanding credit card debt. Fluctuating expenses like utilities, taxes, gas, memberships, and groceries aren’t included.

As an example, let’s say your debt obligations are:

• $1300 for monthly mortgage or rent
• $575 for an auto loan
• $300 for a student loan
• $600 for a credit card

The total amount of debt is $2,775.

Divide that number by your monthly gross income, the amount you make before taxes. Let’s say you bring in $7,500 a month. Your debt-to-income ratio is 37%.

A debt-to-income ratio calculator can help crunch the numbers for an accurate DTI assessment.

Generally speaking, a good debt-to-income ratio is considered below 36%. DTI ratios between 36% and 43% are considered fair, and DTI ratios above 44% are considered high and may indicate financial distress. Every mortgage lender will have specific eligibility requirements regarding acceptable DTI ratios, so check with the institution you’re considering using.

How to interpret your DTI ratio

Knowing where your DTI falls can help you make decisions about managing your finances. 

DTI ratios below 36% tell the lender that the borrower has a balance between debt and income. You don’t need to improve the debt-to-income ratio to qualify for an attractive loan package. Still, you’re welcome to take any measures you want to improve your financial health.

DTI ratios between 36% and 43% are considered fair but may still indicate some financial strain. Lenders will look closely at why the DTI is higher, such as how much of the debt is servicing a mortgage, car payments, or credit card payments.

DTI ratios above 43% are considered high. They may indicate that the borrower is at risk of not meeting all their financial obligations. If this is the case for you, then it’s important to reduce this percentage as soon as possible.

Why you want a low DTI

What real estate investor or homeowner doesn’t want the lowest rate and most favorable terms? Low DTI ratios can help you qualify for these top-tier loan packages with favourable interest rates. The score is a positive sign to potential lenders considering approving new debt that you have control over your spending. 

It also means you have flexibility in your budget. You can handle the additional debt payments without being too financially strained. You likely have income available to save, invest, and spend.

Lenders see a high debt-to-income ratio as a greater risk. Suppose they do decide to approve the loan or credit. In that case, they likely will underwrite higher interest rates, stricter penalties for late payments, and tougher terms. You may be asked for a higher down payment, too.

What lenders look for in DTI

As mentioned, lenders use the debt-to-income ratio to indicate adequate income and good creditworthiness, but there are two kinds of DTI calculations. Borrowers with low back-end ratios are more capable of making their monthly debt payments on time, presenting less risk.

Lenders also run a front-end-debt-to-income-ratio, which calculates how much of a person’s gross income goes toward housing costs. A lender may reject an application if the mortgage payment, property taxes, HOA fees, and homeowners insurance take up more than 28% of the borrower’s gross income.

When it comes to credit card debt, a lender may consider any payments above 10% of pre-tax earnings too high. Additionally, lenders will look at the total amount owed to the credit company and compare it against the borrower’s monthly income to determine if they can afford to pay their debts on time.

Tips for Improving Your DTI Ratio

If your DTI ratio is above the recommended levels, you can improve it. It boils down to two factors: less debt or more income.

1. Reduce monthly debt payments

The fastest way to change the DTI is by paying off debt, like a student loan or car loan.

Not everyone can make a lump sum payment on an outstanding balance. In that case, you have two strategies for reducing debt:

• Snowball method. Focus on paying off the smallest outstanding balance first. Roll that monthly payment into the next-highest debt. Roll the money into the next highest balance when that is paid off.
• Avalanche method. This is the opposite of the snowball method. Instead of focusing on paying off the smallest balance first, pay off the highest-interest debt first.

Both methods work to reduce the amount of money you owe each month and lower your DTI ratio. Run some calculations to see which method benefits you the fastest.

2. Lower interest to lower debt

Dropping your interest payments can be a tactic to decrease your DTI. For example, monthly credit card payments would decrease if you transferred your credit card balances from a high-interest rate to a low-interest rate credit card. Even though your total debt remains the same, your DTI ratio and total monthly debt payments would decrease.

Debt consolidation is also an option. Consolidating your existing debt can help lower interest payments and make debt repayment more manageable.

You could also refinance your existing loans if they have a high-interest rate. So, if you have a 5% 30-year fixed-rate home loan, refinancing to 4% could reduce your DTI ratio and monthly payments significantly.

3. Increase income

Consider ways to increase your income, such as working a second job, starting a side hustle, or asking for a raise.

4. Practice personal finance habits

Responsible spending habits and budgeting help you track where your money is going and avoid financial stress.

As you prepare for a home loan, it’s in your best interest not to apply for any new credit cards or loans. Even a low-limit credit card can affect your DTI if you start charging items.

Monitor your credit utilization. Around 30% is ideal for keeping your DTI back-end ratio in check.

Debt-to-Income is not the only factor

The DTI ratio is essential but not the only determining factor in a lender’s decision to underwrite a loan. A borrower’s past credit history and score also play a role.

Lenders pull credit reports to see your entire borrowing history and credit score. They’ll verify your current debt amount. The credit report also shows late payments, delinquencies, the number of open credit accounts, and your credit utilization–the balances relative to credit limits across all cards. The FICO credit scores are numeric values assigned to individuals based on the information demonstrated in the report.

Not everything out there uses the DTI ratio. It’s a factor in a mortgage loan, but other types of loans may be satisfied with proof of income and employment paired with a good credit score. If you’re seeking a personal or auto loan and have a low credit score, the lender may see if you have a high DTI ratio before approving a loan.

Final thoughts on DTI

Knowing how much money you owe each month relative to what you make is essential in managing your finances responsibly. High debt has significant implications for long-term financial security and investment potential. 

By calculating and understanding your DTI ratio, you can take steps to improve your financial situation, if necessary, and ultimately achieve your financial goals. This is especially true if you’ll be applying for a home mortgage soon. Lenders will use DTI ratios in their screening process. Be prepared before you start seeking financing.

DTI ratio can also help set a budget for your next home. Figure out how much you can spend in monthly payments and still have a reasonable DTI. Investors can run the numbers out to set their budget and then start searching a database for qualifying homes.

Many people with a large sum of money in their retirement accounts are looking for ways to invest outside the traditional options. According to the Investment Company Institute, US retirement assets held in IRAs total about $11.7 trillion (Q2 2022).

While the stock market has been a great place to invest in over the last few years, owning publicly-traded stocks can sometimes feel like riding a roller coaster. Investing in real estate is a popular way to diversify your retirement portfolio and take advantage of long-term appreciation, and it can be a more stable option than stocks, mutual funds, and bonds.

By using self-directed IRA (SDIRA) funds, investors can purchase real estate without paying taxes on gains or rental income until distributions are made, making self-directed IRAs an attractive option for real estate investors looking to buy rental properties or other commercial or residential investment property. In addition, with this type of IRA, you can control where your money is invested and choose properties that fit your investment goals.

What Is a Self-Directed IRA and How Does It Work?

A self-directed IRA – also known as a Checkbook IRA – is a retirement savings account that allows you to invest in alternative assets beyond stocks and bonds. The self-directed nature of the SDIRA allows for diversification with more investment options, including real estate, private companies, tax liens, and precious metals. When using an SDIRA to buy real estate, you can use pre-tax money from a traditional IRA or after-tax funds from a Roth IRA in your retirement account.

Essentially, with a self-directed IRA, you are your own investment manager. This means you will need a solid understanding of the different types of investments available and how they work before making any decisions. The account holder will also be responsible for doing their due diligence on potential investments.

When investing in real estate through a self-directed IRA, all income and expenses associated with the property must flow through the retirement account. Profits generated from the investment can be withdrawn when the investor reaches retirement age, allowing them to take advantage of tax deferment or tax-free gains.

The contribution limit for 2023 is $6,500 ($7,500 if you are 50 or older). Investors have the option to open a traditional or Roth self-directed IRA, with the same pre-tax and post-tax contributions set by the Internal Revenue Service. Because of these limits, investors may finance self-directed IRAs through retirement funds rolled over from different accounts.

Pros and Cons of Using a Self-Directed IRA To Buy Real Estate

One of the main benefits of investing in a self-directed IRA is that you can earn higher returns than possible with a traditional retirement account. In addition, with more control over your investment choices, you can invest in higher risk/higher return assets if you so desire.

Of course, it’s important to remember that there’s also the potential for more significant losses when investing in high-risk assets. So, as with any investment decision, it’s essential to weigh the potential risks and rewards before making any decisions. 

Pros

There are many potential benefits to including real estate in your self-directed retirement portfolio, such as rental income and tax advantages:

• Ability to invest in a wide range of real estate assets.
• Tangible investments as opposed to paper stocks and bonds.
• Opportunity to diversify retirement portfolio beyond traditional financial products.
• Tax-deferred income and gains could lead to higher returns.

Cons

While self-directed IRAs may offer certain benefits, they also come with some potential drawbacks, including:

• Accessing cash flows and gains before age 59 ½ can result in income tax and penalties.
• Buying, managing, and selling real estate with a self-directed IRA is subject to strict regulations that must be followed carefully to avoid significant taxes.
• Tax benefits such as claiming depreciation are not available through self-directed IRAs, so investors cannot benefit from income-offsetting operating losses.
• Finding an approved self-directed real estate IRA custodian may be challenging, as only a few financial institutions offer these plans.

How To Set Up an SDIRA Account

If you’re interested in setting up an SDIRA, there are two main options: custodial and checkbook. Let’s take a look at the pros and cons of each option.

SDIRA Custodian Accounts: The Pros

When you set up an SDIRA with a custodian, you entrust your account to a qualified third-party trust company. The IRS maintains a list of approved nonbank trustees and custodians that you can access at https://www.irs.gov/retirement-plans/approved-nonbank-trustees-and-custodians.

Custodial accounts have several advantages:

1. You don’t have to worry about managing the day-to-day details of your account. That’s the custodian’s job.
2. Custodians are experienced in handling IRAs and other retirement accounts. They know the ins and outs of the law and can make sure that your account stays in compliance.
3. Many custodians offer online portals where you can view your account balance and activity and invest in preapproved investments.

SDIRA Custodian Accounts: The Cons

One downside of using a custodian is that you will likely have to pay fees for their services. These fees vary widely, so it’s important to research and shop around before selecting a custodian. Another potential downside is that you may have less control over your account than if you were to handle it yourself. For example, some custodians may limit the investments that you can make or require that you get approval before making certain types of investments.

Checkbook SDIRA Accounts: The Pros

A checkbook SDIRA gives you more control over your account because you are the account’s trustee and have direct control over all aspects of it. This includes making investment decisions, writing checks, and transferring funds. You also won’t have to pay any fees to a third-party custodian.

Checkbook SDIRA Accounts: The Cons

Of course, with this increased level of control comes increased responsibility. For example, you will be responsible for ensuring that all transactions comply with IRS rules and regulations. You will also need to keep good records of all activities in the account if the IRS ever audits you. And because you’re handling everything yourself, there’s always the risk that you could make mistakes that could cost you money or get you into trouble with the IRS.

Steps Involved in Buying Real Estate With a Self-Directed IRA

Once you’ve decided on the type of self-directed IRA account you want to use, there are several steps involved in buying real estate with an individual retirement account:

1. Find a self-directed IRA custodian or trustee for your account. You should research different providers and compare their fees, services, and investment offerings to ensure they meet your needs.
2. Open the self-directed IRA account with the custodian or trustee by submitting all required documents, such as proof of identity and other financial documentation. Once your account is set up, you can begin investing in real estate using your self-directed IRA funds.
3. Identify the type of real estate you want to purchase. You should consider factors such as location, property type (residential or commercial properties), and potential for long-term appreciation.
4. Locate an appropriate self-directed IRA real estate investment. This can be done through online real estate marketplaces like vantage or by working with a qualified broker specializing in self-directed IRA investments.
5. Complete the purchase process. This includes researching local laws, obtaining financing with a non-recourse loan (if necessary), and closing the deal. When buying self-directed IRA real estate, it is important that all purchases are made with only funds from your self-directed IRA account – not your personal funds – to ensure that you comply with IRS rules and regulations.
6. Finally, you must manage your self-directed IRA real estate investments according to IRS regulations. This includes submitting all required paperwork, filing annual tax returns, and tracking income and expenses associated with the self-directed IRA investment property.

Rules To Keep in Mind When Investing in Real Estate With a Self-Directed IRA

If you’re using a self-directed IRA to invest in real estate, there are some additional guidelines you’ll need to follow:

• To remain compliant with IRS rules, all real estate purchases must be made with funds from the self-directed IRA account and not personal funds.
• Self-dealing by selling property to a disqualified person, such as yourself, or a related party, such as a family member, are prohibited transactions by the IRS.
• Real estate investments in a self-directed IRA must be titled under the name of the IRA owner and not you since it is considered its own entity separate from yourself.
• Self-directed IRAs can participate in joint venture real estate opportunities or partnership investments using a combination of funds to purchase property.
• Management and leasing fees, utilities, maintenance costs, and property taxes for an IRA-owned property must all be paid through funds within the IRA.
• All income generated through real estate investments with a self-directed IRA must stay within the IRA and be paid directly to the IRA.
• UBIT may apply to investment income generated from financed rental property held in a self-directed IRA, but investment income exempt from UBIT includes real estate rental income, interest income, capital gain income, and dividend and royalty income from business ownership.

Tips for Investing in Real Estate With an IRA

When done correctly, investing in real estate with an IRA can be a smart way to diversify your portfolio and build long-term wealth. However, there are a few things to keep in mind. First, working with a reputable and experienced IRA custodian is important. They can help with the paperwork and ensure that all transactions are completed properly.

Second, be sure to do your homework on any potential investments. Location is key in real estate, so research the market carefully before making any decisions. Additionally, you’ll want to be sure you’re not putting all your eggs in one basket. Diversify your portfolio by investing in multiple properties in different geographic areas.

Finally, remember that an IRA is a long-term investment. So don’t be tempted to cash out or make early withdrawals – hold onto your property for the long haul and reap the potential rewards down the road. One of the key benefits of investing in real estate through an IRA is that you can hold onto the property for as long as you want. This means you can wait for the perfect opportunity to sell or let the property appreciate over time.

Following these tips can help you maximize the potential of your self-directed IRA and make wise investments that will provide long-term growth and security.

Closing thoughts on SDIRAs

Self-directed IRAs can be a great way to invest in real estate, but it’s important to understand the risks and rewards associated with this type of investment before making any decisions. If you’re considering using your SDIRA funds to purchase a rental or residential investment property, research the market carefully and consult an experienced financial advisor.

As a real estate investor,  finding profitable properties and gauging whether they’re likely to be an excellent long-term investment is vital to ensuring that you make—and not lose—money on the deal. In addition to in-depth research on a property, the neighborhood, the historical growth in the area, and the future developments that are planned around the property, intelligent real estate investors also rely on several metrics that help give them a decent idea of whether to proceed with an investment or not. 

One of the most common measures of a property’s investment potential is the Capitalization Rate. In this article, we’ll talk about what the capitalization rate is, how to calculate it, and when it’s most likely to come in useful.

What is the Cap (Capitalization) Rate?

Capitalization Rate, or “cap rate” for short, is used in commercial real estate to calculate the rate of return on a real estate investment property. Calculated by dividing the property’s annual Net Operating Income (NOI) by its property value, the Cap Rate is used to estimate an investor’s potential return on investment on that particular purchase. That is, it estimates how long it will take to recover the initial investment on a property. 

The Cap Rate is a very popular metric widely used to quickly compare the returns on similar properties when making an investment decision. However, like most other metrics in real estate, the Cap Rate is an indicator of overall trends and is not infallible. 

The Cap Rate should be one of several metrics used to evaluate a property and requires due diligence and attention to detail to calculate correctly. Still, when used correctly and in combination with other real estate metrics, the Cap Rate can be an excellent tool for investors to mitigate risk and make wise and informed decisions about potential properties to add to your portfolio. 

How to calculate the Cap Rate

Calculating the Cap Rate can be done through a simple formula, but to do so, we need to arrive at a few numbers first. The Cap Rate formula looks like this:

Cap Rate = Net Operating Income / Current Market Value

Here are the steps to calculating a property’s Cap Rate.

1. Calculate the property’s Net Operating Income (NOI)

The Net Operating Income or NOI is the total of a property’s income minus the total of the property’s expenses. Expenses include property taxes, insurance premiums, repairs, property management fees, and marketing or legal cost. These are annual calculations, so you’ll want to take your gross rent and multiply it by 12. Then do the same for your expenses. 

There are two important considerations to make when calculating the NOI on a property:

1. Rental income: If the property isn’t currently rented, you’ll need to estimate the rent to make your calculation. You don’t want to overestimate since this could make the property appear to be a more valuable investment than it is. Still, you don’t want to underestimate either because you could lose out on a potentially significant investment if the numbers aren’t accurate. Look at the going rate for similar buildings with similar amenities in the same neighborhood and, if the place has been rented before, determine what the going rate was and if it reflected a fair market rate. 
2. Vacancy rate: It’s easy to forget this vital fact when estimating, but most rental properties will sit empty part of the time. Even with single-family and multifamily homes, you may have vacancies if a family decides not to renew their lease and you’re unable to find new tenants in time. While you don’t want to inflate numbers too much, it’s wise to err on the side of caution with the vacancy rate. Typically, investors assume an average of 10% vacancy, but it’s worth looking at similar properties to arrive at a more realistic number. 

Once you’ve factored in all the variables, subtract the property’s annual costs and expenses from the property’s annual income. This is your NOI.

2. Divide the NOI by the property’s asset value

Now you’ll divide the NOI we’ve just calculated by the property’s current asset value. There is some debate about whether the property’s asset value is the current market value or the property’s purchase price. The purchase price is the least preferred number because if the property was last purchased years or decades ago, the purchase price could be meager. Properties can also be inherited, making the sales price zero. Current market conditions tend to be more reflective of a property’s potential and are, therefore, more commonly used. 

Since Cap Rate is often expressed as a percentage, once you’ve divided the NOI by the property’s current market value, multiply that number by 100 to arrive at the Cap Rate.

Factors that influence the Cap Rate

It’s important to understand that in addition to the Cap Rate calculation we’ve done, a number of factors can impact and lead to different Cap Rates. These include: 

• Location: You’ve heard it said before, but a large part of the profitability in a real estate investment comes down to location. The less risky the location, the lower the cap rate is likely to be. 
• Competing properties: How competing properties are doing in the local market will likely impact your Cap Rate. Generally, properties in established real estate markets with high growth rates and more developed infrastructure will have lower cap rates. 
• Capital investment: If you’ve invested in a renovation to make a property more attractive to potential tenants and command higher monthly rents, this investment will increase your operating income and directly impact your NOI. 

A variation of the Cap Rate is the Gordon Growth Model, sometimes also known as the Dividend Discount Model (DDM) and used in finance to value a stock with dividend growth. This model is used by investors who expect their NOI to grow each year at a constant rate. The formula for the Gordon Growth Model is:

Stock value = Expected annual dividend cash flow / (Required rate of return – Expected dividend growth rate)

The formula can be applied to real estate to calculate the asset value of a property. When you factor in your expected growth rate, this helps you decide whether the property is worth purchasing at its offered price. 

When to use Cap Rates

The Cap Rate is most useful when evaluating the long-term risk potential of rental properties that you expect will yield a regular, predictable income stream. Investors will frequently use the Cap Rate when considering property types, including: 

• Single-family homes
• Multifamily rentals
• Apartment buildings
• Commercial properties

The Cap Rate isn’t a handy metric for properties that don’t provide stable income or have irregular cash flows. For instance, your net income will fluctuate with Vacation Rentals from month to month based on seasonal tourism. Your operating expenses will also vary, such as extra cleaning and maintenance costs during the months of high tenant turnover. If you’re planning to flip a home, you won’t be using the Cap Rate since your goal is to renovate and sell as quickly as possible. 

Also, don’t forget that Cap Rate assumes that the property is paid for in cash and, therefore, doesn’t consider the costs of a mortgage. 

Real estate investing is broadly accepted as a Long-term way to build generational wealth. And while most experts will attest to this fact, it only applies to intelligent, profitable investments that generate high year-on-year returns and cash flow. 

This is why, as a real estate investor, one of the most important things you can do when purchasing a property is to run the numbers diligently to ensure that the real estate investment you’re making will give you a high return and continue to generate a profit for a number of years—and decades—to come. 

Knowing how to calculate your return on investment is critical, and in this article, we’re going to discuss what return on investment means, how to calculate the profitability of an investment, what ROI metrics to use, and how to know whether a property will offer a good return on investment in the long term. 

What is Return on Investment?

ROI, or return on investment, is a metric calculated to determine the profit earned on any investment, including a real estate investment, after deducting all associated costs. 

When speaking specifically of real estate, the return on investment is Vantage Horizon  at after deducting the purchase and initial costs of the home and any additional expenses incurred, such as repairs or remodeling costs, from the current value. ROI is not realized until the property is sold, though it is an important number to keep in mind when purchasing to see if it can become a profitable asset. 

The simple ROI formula is: 

ROI = (Present value of investment – Cost of the investment) / Cost of total investment

Or, to say it even more simply:

ROI = Net income on investment / Cost of the investment

While the formula is simple, calculating a meaningful ROI percentage for an investment property is not. It is challenging because numbers in real estate investments are often estimates or guesses and can be hard to predict with absolute certainty. 

It’s also important to consider how many ways to purchase a property and calculate the net profit. While some investors will purchase a property outright with cash, others will get a mortgage, adding to ongoing expenses but resulting in less upfront cost. 

Again, you may choose to offer your property as a short-term or long-term rental or simply hold it for appreciation, and how that property is used will also impact its profitability. 

So, while ROI is an important number and one that every real estate investor must consider, it’s essential to note that there are many ways of arriving at this number and that if you’re looking for accuracy, you might want to consider calculating the ROI in addition to several other numbers at your disposal, such as capitalisation rate, internal rate of return (IRR), cash-on-hand return, and annualised ROI, which also considers the length of time you hold the initial investment. 

If you’re an experienced investor or real estate business owner, you also want to look at corporate finance numbers to determine how investment costs and investment gains impact your overall portfolio. You’ll want to calculate Return on Assets (ROA), for instance, which is the measure of the profit a company or property makes relative to its assets or costs over a period of time. Return on Equity (ROE) measures a company’s net income divided by its shareholders’ equity.

Of course, a negative ROI number would indicate that this is a loss-making property and you’d be well served to think of this particular investment as best avoided.

Understanding ROI variables

The key thing about the ROI on real estate investments, which makes them different from other investments, is that real estate ROI can often depend highly on variable factors, including local market conditions, type of property (single-family homes, multifamily units, vacation rentals, or commercial real estate) and how much rent a property can command. These limitations of ROI can be influenced by factors such as: 

Market conditions

What will impact ROI on a property most are the overall real estate market conditions. In a seller’s market, there is limited inventory available, which means that a large number of buyers will be competing for a small number of available properties, pushing the purchase price up over a certain time frame. On the other hand, a buyer’s market will slow down both sales and prices. 

Market conditions at the time of purchase matter are easy to overlook, but they matter too. If you bought a property in a seller’s market, you might have less gains to make and, therefore, a lower ROI unless the market appreciates significantly. 

Location

Properties in metropolitan cities such as New York and San Francisco, tourist attractions such as Joshua Tree, and billionaire favorites such as Palm Beach appreciate faster than regions in other parts of the country. This can significantly impact the ROI in the short and long term. A residential property close to excellent schools will have both high sale and rental valuation, while an apartment near a highway will get fewer people interested and, therefore, lower prices. 

Costs of purchase and maintenance

How much you paid to purchase a home will factor into your ROI calculations and what you spent to fix it up and renovate it. Ongoing maintenance costs are essential to factor into any calculations. 

Crucially, mortgage interest rates will also impact your profits when dealing with different investment opportunities. When interest rates are high, your profits will not only decline in real terms, but your house prices may also go down due to the impact on the overall real estate market. Also included in this equation will be taxes–including the capital gains tax incurred when you hold a property for over a year before selling. 

ROI for different types of investments

When calculating ROI for a real estate investment, it’s also important to look at the type of real estate investment. For instance, ROI is often a straightforward calculation in cash and resale transactions. You calculate your profit by subtracting your expenses, which includes the price you paid for the property as well as any money you’ve spent on it from the total revenue. You then divide that number by your total cost or investment. 

For a financed rental property, however, you’ll need to calculate your projected annual rental income and operating expenses. These include insurance, property taxes, HOA dues, and day-to-day maintenance costs. You’ll also want to factor in the marketing and legal costs of finding and vetting tenants. 

How to maximize your real estate ROI

As an intelligent investor, maximizing the ROI from your investment property should be one of the top things you look at when making a real estate purchase. Here are some things to consider that will help you increase your ROI.

1. Keep the property in good condition: Especially when renting out your property, it’s important that you perform regular property maintenance and renovations. This will ensure you don’t get hit with unexpected and costly bills because of issues you’ve missed.
2. Reduce operating costs: It might sound contradictory to the point above, but you want to reduce your operating costs whenever possible. This is more than just about expenses, though. Keep on top of mortgage and insurance rates and have them reduced when you can, pay for quality upfront so that things don’t break or malfunction often, and when required, hire professionals, such as real estate agents and management companies, to do what’s required faster.
3. Do your research: When looking for investment properties, do your research by looking at similar properties in the same or similar neighborhoods. By looking at the numbers on those properties and using that as a template, you’ll be able to arrive at more accurate estimates for your potential purchase as well. 

The bottom line

While purchasing a physical property is a fantastic way to invest in real estate and build generational wealth, it is not the only way. Through Arrived, you can own shares in real estate properties around the US, no matter whether you have $10,000 or $100,000,000 to invest. Our mission is to give everyone—regardless of background and income level—a chance to get on the property ladder.

For real estate investors hoping to maximize their rental property’s value and profit, understanding how to accurately measure vacancy rate is essential. This metric can substantially influence your net operating income (NOI), return on investment (ROI), and overall worth of a rental property.

In this blog post, we’ll discuss the vacancy rate, historical occupancy rate trends in the US, different methods for measuring vacancy, and tips for investors to help keep vacant units low at their properties.

What Is A Vacancy Rate?

A vacancy rate is an essential metric in real estate investing. It is the percentage of days in a building or portfolio of buildings not occupied by tenants over a specific period of time.

By tracking their vacancy and comparing it to similar properties in the local real estate market, investors, real estate agents, and property management can better understand what strategies will help them maximize their returns on rentals and increase property valuations by avoiding high vacancy rates. This information can also provide insight into improving tenant retention rates, which is critical for an investor’s bottom line.

Additionally, comparing the overall vacancy rate locally will help investors understand current trends in rental demand and short-term fluctuations in supply and demand. By understanding these dynamics in the local rental market, investors can ensure that they are making the most of their investment opportunities.

How Ro Calculate Vacancy Rate 

To calculate the vacancy rate using the number of days method for an entire year, follow these three steps:

1. Start by adding up all of the days a property is empty during a given year (365 days)
2. Divide this total number of days by 365 to get the average percentage representing the vacancy rate
3. If a property were empty for 30 days over the entire year, its vacancy rate would be 8.2% (30 / 365 = 0.082 x 100% = 8.2%)

The above example shows how easy it is to calculate vacancy for one single-family home. However, calculating the rate for a number of vacant units can be more complicated because the rates of each unit are likely to differ. This means that when calculating the total vacancy rate, it is necessary to consider all individual units and the days each is unoccupied. 

Multifamily Property 

Here is an example of how to calculate the vacancy rate for a 3-unit multifamily property, with one unit being vacant for 30 days of the year, the second unit for 45 days, and the third fully occupied during the entire year:

• Determine the number of rentable days by multiplying the total number of units by 365 (3 x 365 = 1095)
• Add up the total number of days that each unit was empty during the year (30 + 45 + 0 = 75)
• Divide this number (75) by the total rentable days (1095) to get the average vacancy rate (75 / 1095 = 0.068 x 100% = 6.8%)

This means that over the course of one year, an apartment building with three available units had an overall vacancy rate of 6.8%.

Rental Property Portfolio 

In this example, we will explain how to calculate the vacancy for a 10-unit portfolio, which consists of five single-family rentals (SFRs) and five vacation rentals:

• Start by determining the total rentable days by multiplying the number of rental units by 365 (10 x 365 = 3650).
• Then add up the total number of vacant days for each unit. For the SFRs, this is 0 + 15 + 30 + 45 + 60 = 150 and for the vacation rentals it is 60 + 90 + 120 + 120 + 180 = 570
• Next, divide the total number of vacant days (150 + 570 = 720) by the total rentable days (3650) to get the average vacancy rate (0.197 x 100% = 19.7%)

This means that over the course of one year, this 10-unit rental property portfolio had an overall vacancy rate of 19.7%.

Why Vacancy Rates Differ By Property Type

It’s important to remember that vacation rentals can sometimes suffer from higher vacancy than long-term rentals due to seasonality and other factors. However, their higher rental rates typically result in increased gross income, making them attractive investment opportunities for those looking to maximize their potential returns. 

When calculating the vacancy rate for a rental property portfolio, an investor can group all the units into one category and calculate the overall vacancy rate or break the portfolio down into individual categories such as single-family rentals (SFRs) and vacation rentals. 

Doing this can prevent the vacancy from being distorted by combining units with a natural rate (e.g., vacation rentals) with those known to have lower vacancies (SFRs). Calculating at the portfolio level makes it easier to compare different portfolios, while calculating at the category level gives more insight into how each type of rental is performing. 

At the same time, both methods can provide valuable information as to whether a portfolio will generate sufficient income compared to similar properties. For instance, if a portfolio has a higher-than-average vacancy rate for vacation rentals but lower than average for SFRs, it could still be a profitable investment opportunity due to the potential of earning more from those short-term stays. 

Historical Vacancy Rate In The US

Investors sometimes ask if there is a “normal” vacancy rate for investment property. We can look at historical US rental property vacancy rates to answer that question. The most recent data from the St. Louis Fed (Q3 2022) indicates that the overall national average rate is hovering at around 6%. Today’s rental vacancy rate is the lowest it has been since 1985, indicating that demand for rentals is growing. 

Factors such as lifestyle changes, an influx of millennials and zoomers (Generation Z) into the rental market, and rapidly increasing costs of owning a home have all contributed to more people renting than owning, creating a consistently declining vacancy rate for rental housing. This situation has been further exacerbated by the current economic climate, presenting landlords with both opportunities and challenges in adapting to this new landscape.

Other Factors Affecting Vacancy Rate

Vacancy rates can also be significantly affected by the location and the time of year:

• In a college town, vacancy rates may peak during the summer months when students are away from campus for an extended break. 
• Vacation rentals will likely experience higher vacancy rates during the off-season when people tend to stay at home due to colder climates or other factors. 
• Suburban single-family rentals where tenants work from home may experience lower vacancy rates because of their convenient location and because people who can work remotely are increasingly choosing to do so. 

Aside from the above factors, having a rental property in an area with a low neighborhood rating can also affect vacancy rates. A low neighborhood rating usually refers to an area with higher than average crime rates, poorer quality schools and infrastructure, and fewer amenities or shopping opportunities. These neighborhoods tend to be less desirable for renters and property owners alike. 

Additionally, failure to properly maintain a rental property or not offering amenities such as updated appliances or attractive finishes can also contribute to reduced occupancy. Landlords must consider all of these factors and take necessary steps to ensure their properties remain desirable for tenants.

Impact In Vacancies On Key Metrics 

Vacancies and tenant turnover can significantly impact rental income, cash flow, and ROI. Vacancies represent lost revenue, as they are periods when the property owner is not receiving rent. During these periods, repairs may need to be done to the units before new tenants move in – resulting in additional costs that will further reduce profits. Tenant turnover also increases expenses as landlords need to cover re-leasing fees, cleaning costs, maintenance, and repairs – all of which add up quickly.

Furthermore, vacancies can lead to a decrease in overall return on investment (ROI). This is because vacant properties have carrying costs such as taxes, insurance, and mortgage payments that still need to be paid without any offsetting revenue from the rental unit. As a result, investors need to consider vacancy rates in their calculations when assessing potential rental property investments and figure out how this will affect their expected return on investment. 

To maximize profits and ensure positive cash flow, investors should focus on strategies that seek to minimize vacancies. Doing so helps ensure their portfolios remain profitable regardless of market conditions.

5 Tips To Keep Occupancy Level High

Keeping occupancy levels high is essential for real estate investors who want to maximize their returns. Vacant properties mean lost revenue, as there is no rent coming in, and carrying costs still need to be paid. That’s why it’s important to ensure that units are well-maintained, competitively priced, and attractive to potential renters. Here are five tips that investors can use to keep their occupancy levels high:

1. Keep rental rates competitive: Knowing the market rent of similar properties helps keep rates in line with what tenants are willing to pay.
2. Market aggressively: Advertise your units to reach a wide variety of potential tenants on various platforms such as websites, social media, and local newspapers.
3. Make the application process easy: Streamlining the application process by offering online forms or pre-screening applicants over the phone can help speed up approvals and increase demand for your properties.
4. Keep your units well maintained: Regularly inspecting and repairing any issues promptly demonstrates that you take care of your property, making tenants feel more secure about their living arrangements.
5. Perform regular home visits: Doing regular walkthroughs lets tenants know that you care about the property and that any maintenance issues will be taken care of quickly.

Final thoughts 

Knowing what a vacancy rate is and how it impacts real estate investors can help them maximize returns on investment while reducing expenses associated with empty properties throughout their portfolios. By considering historical market vacancy rate trends in a particular area, utilizing various methods of calculating vacancies wisely, minimizing voids through pricing strategies, and intelligent management techniques—real estate investors can enjoy strong returns across multiple rental property investments over time.

Finding a rental property with a low vacancy rate can be challenging, even for the most experienced real estate investors. With numerous investment opportunities available, navigating the unknowns and managing properties can be challenging.

That’s why Vantage Horizon provides investors with a way to reduce risk and simplify processes when searching for investments.

Debt service coverage ratio (DSCR) is a ratio that compares a company or individual’s total debt obligations to its income. Lenders use it as a metric to determine a borrower’s financial health. For a company, it can be the determining factor on a business loan. For an individual, it can be the determining factor on a car, home, or small business loan.

But how does it apply to real estate investing?

Let’s take a closer look at DSCR and how lenders and investors in real estate use it.

Key takeaways:

• The debt service coverage ratio in real estate indicates a property’s financial health.
• Most real estate investors consider a good debt service coverage ratio to be at least 1.25.
• DSCR changes over time.
• Real estate investors and lenders use DSCR to analyze a property’s performance.

What is the debt service coverage ratio?

In real estate, the debt service coverage ratio is a metric that helps analyze an investment property’s performance.

DSCR measures the borrower’s (investor’s) ability to repay the annual debt service compared to the amount of net operating income (NOI) a property generates. It’s an indicator of whether or not a property generates enough income to cover the mortgage payments.

When a real estate investor applies for a new loan or refinance, lenders use DSCR to determine the maximum loan amount.

What’s a good DSCR?

There is no standard for a good DSCR because it varies by situation and lender. However, there are some general guidelines real estate investors can follow.

A DSCR below 1 means the property doesn’t generate enough income to cover its debts. A DSCR of 1 means that 100% of the property’s NOI goes toward paying its debts. A DSCR above 1 indicates the property has a higher NOI than is needed to pay annual debts.

For most real estate investors, a good debt service coverage ratio is at least 1.25.

How to calculate DSCR

Calculating the debt service coverage ratio is pretty simple. In real estate, it’s calculated by dividing a property’s annual net operating income (NOI) by its total debt service. NOI is essentially all of the cash flow the property generates.

Here’s the debt service coverage ratio formula.

DSCR = NOI / Debt Service (principal and interest payments)

Here’s an example of how to use it.

Let’s say a real estate investor wants to refinance a rental property to take advantage of lower interest rates. The property has an annual NOI of $7,000, and the annual mortgage payment is $5,000 (including principal and interest). They want to perform a DSCR calculation before they go to the lender. So, they plug the numbers above into the DSCR formula.

DSCR = NOI / Debt Service

1.6 = 8,000 / 5,000

In this example, this rental property has a DSCR of 1.6. This means there is extra net operating income than is needed to service the annual debt.

How to calculate NOI

Net operating income (NOI) is essential to calculating the debt service coverage ratio, the mortgage loan amount a real estate investor can get, and the amount of income they have available for debt repayment. It’s essential to know how to calculate NOI correctly.

And here’s why.

A net operating income that’s miscalculated too high can lead to an investor who is unable to repay their debts. An NOI miscalculated too low can prevent an investor from getting loans for more properties.

NOI is calculated by adding up all income a property generates and subtracting all operating expenses.

Here’s the net operating income formula.

NOI = Gross Operating Income / Gross Operating Expenses

The first step in calculating NOI is to calculate gross operating income.

Here’s how to calculate a property’s gross operating income.

Gross Operating Income = Potential Rental Income – Vacancy Rate

Potential rental income includes the monthly rent a tenant pays plus any extra income from the property. This may include pet rent, utilities, or storage unit fees.

The second step in calculating NOI is calculating the property’s vacancy rate. It’s unrealistic to assume a rental property will always be occupied. That’s why some real estate investors use a 5-10% vacancy rate, but it’s not always reflective of the market. The best way is to review the property’s records and talk with a local real estate agent to understand vacancy rates in the local market.

Here’s an example of how to calculate gross operating income.

Let’s say a real estate investor has a rental property with a potential rental income of $5,500 per year. They reviewed the property’s records and consulted a real estate agent to determine a vacancy rate of 10%.

Gross Operating Income = Potential Rental Income – Vacancy Rate

4,950 = 5,500 – 550

The property has a gross operating income of $4,950 per year.

Now it’s time to calculate the property’s annual operating expenses. These typically include property management fees, maintenance, property taxes, insurance, utilities, and HOA fees. They do not include necessary expenses like capital expenditures (CapEx), mortgage payments, depreciation, and debt service.

Once an investor has determined their gross operating income and operating expenses, they can determine their net operating income.

Let’s use the example above, where the investor’s property has a gross operating income of $4,950 per year. The property’s operating expenses are $2,000.

NOI = Gross Operating Income – Operating Expenses

2,950 = 4,950 – 2,000

In this example, this property has an NOI of $2,950.

How DSCR is used in real estate investing 

Investors and lenders use the debt service coverage ratio in the real estate investing process.

Let’s say a real estate investor wants to purchase a rental property that’s listed for $175,000.

Before they make their offer, the investor talks with their lender and learns the lender requires a minimum DSCR of 1.25.

The investor talks to the property owner and anticipates a net income of $8,5000. They use this information and minimum DSCR to calculate the annual debt service the lender will allow and the down payment needed.

Here’s how.

They rearrange the DSCR formula to calculate the maximum allowable mortgage payment.

Debt Service = NOI / DSCR

6,800 = 8,500 / 1.25

The investor meets with the lender and learns they’ll need to put a minimum 20% down payment on the property to qualify for the loan. The investor can then determine if this is the right property for them or use the information to shop around in different real estate markets.

Does DSCR change over time?

Yes. The debt service coverage ratio of an investment property will change over time. This is due to several factors like fluctuating net operating income.

Here’s an example.

The above table assumes the investor took out a mortgage with traditional terms and amortization where the principal and interest payments remain the same. There can be even greater fluctuations in DSCR if the debt service changes over time due to different loan terms that result in changes in loan payments.

The bottom line

DSCR is commonly used in finance to determine a company or individual’s financial health. In real estate, it’s used to determine a property’s financial health because it relies on the property’s NOI versus the investor’s income. A good DSCR is 1.25 or higher because it indicates the property’s net operating income can cover its debt service plus 25%. Use DSCR as a guide when determining whether or not an investment property is right for you

For companies and businesses, the net worth or the capital of the company is determined by calculating the difference between the assets and the liabilities. This is also known as net assets. But in order to understand a “per-share” value of a fund and determine its valuation and pricing, the NAV is a more important metric to use. This is important because the NAV helps determine the book value of a business, and it’s an important metric used to understand a company’s growth prospects and find undervalued or overvalued investments. The NAV is also used to evaluate the performance of funds.

In this article, we’ll talk about Net Asset Value (NAV), what it means, how to calculate it using the NAV formula, and how it’s used in business valuation.

What Is Net Asset Value?

Net Asset Value (NAV) is defined as the value of a fund’s assets minus the value of its liabilities. Net Asset Value is a term most commonly used in relation to a mutual fund or an exchange-traded fund (ETF). NAV is the trading price of shares of the funds registered with the  US. Security Exchange Commission (SEC).

The SEC rules dictate that mutual funds and Unit Investment Trusts (UITs) must calculate their NAV at least once every business day.

The NAV is calculated by subtracting a fund’s total liabilities from its total assets and then dividing that by the total number of outstanding shares. It helps to see the per-share value of a mutual fund.

For example, if a fund’s assets are $30 million and its liabilities $10 million, its NAV will be $20 million. If in our hypothetical example, the fund has one million shares outstanding, the NAV per share will come to $20. That is, for the given day, the mutual fund shares will be traded at $20 per share.

It’s important to remember that since the value of the fund’s assets and liabilities of an investment fund fluctuates frequently, the NAV will change from one day to the next.

Calculating NAV

The Net Asset Value formula is as follows:

Net Asset Value = (Value of Assets – Value of Liabilities) / Total Shares Outstanding

Let’s break this down further.

Value of assets: The value of a mutual fund’s assets is the total market value of the cumulative investments of that particular fund. It includes cash receivables or cash equivalents, dividends, interest payments, and accrued income.

Value of liabilities: This is the total amount of money owed to banks, pending dividend payments, and audit fees. It also includes operational expenses, such as management salaries, rent, utilities, and distribution expenses.

Shares outstanding: This refers to the company’s stock currently held by shareholders. The number includes share blocks held by institutional investors, as well as restricted shares. A company’s number of outstanding shares changes daily.

Understanding NAV

The Net Asset Value calculation is important because it’s the price at which a mutual fund investor can buy or sell shares. In a closed-end fund that trades in a public marketplace, the NAV is the value of a fund’s assets, which can be compared to the market price to evaluate its market value. For private equity funds, the NAV helps investors see the fund’s residual value and determine the fund’s performance.

Mutual Funds and NAV

Mutual funds take money from numerous investors, which is then used to invest in stocks, bonds, and money market instruments. Each mutual fund will have a different portfolio based on the fund’s investment objectives, the securities its holds, and how much it expects to achieve in returns. Investors get shares in the fund proportional to the amount of money they’ve invested. The pricing of each share in a mutual fund is based on the NAV.

Unlike stocks, which are traded on the stock market throughout the day, mutual funds are priced at the end of the trading day, the cutoff time being the end of trading. Mutual funds are required by SEC regulatory rules to calculate their NAV per share daily, and that becomes the next day’s trading price. The mutual fund NAV is calculated by the fund managers by adding up the closing price of all the securities in its portfolio, adding the value of any additional assets, subtracting the liabilities, and then dividing by the number of shares outstanding.

While most mutual funds are open-end, which means they’re issued and repurchased directly by the fund, there’s also another type of fund known as closed-end funds.

Open-end Funds NAV

An open-end fund doesn’t trade on exchanges, and they are priced based on its end-of-day NAV price. Mutual funds are open-end funds. An open-end fund can issue an unlimited number of shares to sell. When shares are redeemed, they are taken out of circulation. A large number of shares being redeemed may require the fund to sell some of its investments.

Closed-end Funds NAV

Closed-end funds are listed on a stock exchange and trade similarly to securities. They’re considered public-traded investment companies. The share price of a closed-end fund is not equal to its NAV and is determined by the values of the assets in the fund’s portfolio. The share price, as well as the supply and demand of closed-end funds, often comes down to a mix of market sentiment, the reputation of the fund’s manager, and management fees. Closed-end funds can trade at a premium above the fund’s Net Asset Value or at a discount below their NAV.

ETFs And NAV

While ETFs, or Exchange-Traded Funds, have many similarities with mutual funds, the biggest difference is that they trade like stocks. With ETFs, the NAV and the market price are not the same. The NAV of the ETF is based on its securities and asset holdings, while the supply or demand in the market dictates the ETF market price. ETFs must calculate their NAV daily, but they also estimate it every 15 seconds throughout the business day.

Again, an ETF may trade at a premium or a discount, and professional traders will employ various trading strategies that seek to profit from buying at a discount and selling at a premium. Understanding the underlying value or NAV is crucial, therefore, to an investor, and historical information about the fund is important to have. This is easy to find because ETFs tend to be more transparent than mutual funds. ETFs release their current holdings, amount of cash on hand, outstanding shares, and received dividends daily. Mutual funds only disclose their holdings every quarter.

Private Equity And NAV

Private equity shares don’t trade on public exchanges. For this reason, the NAV becomes an important valuation metric that allows investors to interpret or measure the residual value of investments held by the fund. The NAV in private equity funds represents the value of an investor’s shares in the fund at any given time. Like other funds, the NAV is calculated by adding all the holdings and assets and subtracting accrued expenses from this number. The resultant figure represents the total NAV for the fund.

Investors can look at the NAV of a fund over time to see how the fund is progressing. It’s, therefore, a good measure by which to measure growth and value. General partners will also use the NAV to determine the price for potential secondary transactions to third parties. The benefit of secondary transactions is that they allow for the liquidation of private company assets that haven’t gone public and can be used to return capital to investors.

NAV in REIT Valuation 

NAV is valuable in real estate as well, specifically when it comes to REIT valuation. A REIT or a Real Estate Investment Trust, is a company designed to own, operate, or finance real estate. When you invest in a REIT, you’re not investing in securities but in real estate holdings.

The NAV in a REIT represents the Fair Market Value or FMV of real estate assets minus any outstanding debt, expenses, and capital expenditures and is the preferred valuation approach for REITs.

The Bottom Line

The NAV calculation is simple but essential and one that you will run into frequently, not only when you purchase mutual funds or ETFs but when you buy real estate. REITs were created by Congress so that anyone could own income-producing real estate. With their high dividends, low risk, and steady returns, REITs have become an excellent way to get started in real estate and earn dividends.

We are excited to announce the launch of Vantage new referral program, which has consistently been one of our investors’ most highly requested features. This program allows you to invite your friends to join Arrived, and you’ll both earn free shares once they sign up. 

To mark the launch of this program, we’re running a special promotion— Share your referral code, and for every person that signs up and find their portfolio using your code, you receive $50, and your friend also receives $50. It’s a win-win situation for both parties!

Here is how it works:

Step 1: Log into your Vantage Horizon account and click on referral on the side menu bar or overview.

Step 2: Copy your unique link or use one of the share buttons to send out your code.

Step 3: Once your friend signs up and fund their account, you’ll get your bonus!

Please note that terms and conditions apply to our referral program, and the referral will only be activated when your friend funds their portfolio account. We also reserve the right to revoke your referral rewards if we detect fraudulent activity.

We hope you use our new referral program and invite your friends to join our platform. It’s an excellent opportunity to earn extra equity shares of Arrived properties and help your friends start investing. If you have any questions, don’t hesitate to contact our Investor Relations Team at support@vantagehorizon.com 

Happy investing! 

The Vantage Horizon Team