What's Your Performance Ratio?|
by Tim Randle
Did you know that Carleton Sheets has been on the television practically every night for close to twenty years? Were you aware that during that entire time his "positive cashflow" numbers have remained essentially the same? Yes, that's right. Almost twenty years ago, Carleton began preaching about receiving rents that were $100 to $150 more than your payment. Anyone recall what the average payment was way back then? I sure don't, but my guess is that it was around $400. I find it strange that those numbers are still being spouted as a decent "positive cashflow" today.. Bankers and finance folks have a term called "debt service coverage ratio" (DSCR). Essentially, what that defines is how much is justify over to cover debt after paying expenses. So, if you have a property that annually generates $20,000 in gross income, $5,000 in expenses, and $10,000 in debt, your DSCR would be 1.5 ($15,000/$10,000), meaning your property throws off an extra 50% above and beyond your debt service. It's simply an objective measurement of financial strength. Having spent a good portion of my adult life dealing with financial analysis, I no longer want to get bogged down with financial terms so I've come up with a simpler variation of DSCR. I call it your "Performance Ratio". It's an easy concept to grasp and it's this. Ignoring all expenses except vacancy, how many performing properties does it take to cover one vacancy? By that, I mean if you have four properties with an average payment of $900 per month, how many of your other properties have to be performing for the "positive cashflow" from those to cover one $900 per month vacancy? If you're using the standard $150 per month as your gross spread (your receipts are $150 more than your payment), you would need six of your properties to perform to cover one vacancy. Oops, you only have four in total. And that doesn't even take into consideration normal maintenance repairs, capital reserves for large item replacements (roofs, A/C's, etc.) Hmmm... But wait. It gets even better. What if you ran out and purchased a large number of these and had payments in the $1,200 to $1,800 range? Let's split it and take $1,500 as our average payment. That means that if our average gross spread is $150 per property, we only need TEN properties to be performing to cover one vacancy. If you didn't pick up on it yet, please note the heavy sarcasm here. This is absolutely a model for failure, bankruptcy, and every other imaginable financial catastrophe. If you're building your business this way, STOP IT NOW! As soon as the market throws a speed bump in front of you, it will not just slow you down as expected, it will total your vehicle. My opinion is that the average Performance Ratio for your portfolio should be no more than three to one (3:1). What that means is that in the first scenario of owning four properties, that the gross spread from three of the properties should cover the payment on the fourth. To say it another way, your gross spread on your property should be one-third of your payment. Here's another benefit this "formula" provides. For those not familiar with the 75% rent credit that lenders use in calculating your income and debt numbers when you attempt to qualify for a loan, this will greatly decrease your risk level in the lenders' eyes. On a monthly basis using our four property scenario, you receive $4,800 per month in rents ($1,200 rent per property equals the one-third gross spread) against $3,600 in payments. The lender multiplies your gross of $4,800 times 75% and allows you $3,600 in income against $3,600 in payments. It's not an exact wash on your debt to income ratios, but it sure helps. Why does the lender do that? Because the 25% deduction accounts for normal operating expenses. I promise you that even with single family houses and even if you manage them yourself, that your expenses over time will average at least 25% of your gross income. Where does that leave us? Well, if we ignore expenses, a Performance Ratio of 3:1 is a self-sustaining business model from the payment perspective . If we ignore vacancies, a Performance Ratio of 3:1 is a self-sustaining business model from the expenses perspective. Won't we have both expenses and vacancies? Absolutely. RRRRRRRRRRRIIIIIIIIIIIIIIINNNNNNNNNNNNNGGGGGGGGG!!!! That's the alarm clock going off, hopefully waking you up to the incredible foolishness of using a nominal, arbitrary number like $150 per month as a desired gross spread. Again, it worked when Carleton first aired because the spread PERCENTAGE worked; the payments were $400 or less. Do I know what the "right" number for you in your market is? Of course not. Does this mean you don't buy a certain property because it doesn't meet this litmus test? Of course not. However, I do want you to give this some serious thought in relation to your current portfolio or the one you plan to build. Don't ignore the numbers as they are real. Know going in where you want to end up so that your business has good odds of succeeding and weathering the tough times.
Tim Randle is a full time investor in Round Rock, Texas and can be contacted through his web site at www.REIClub.com.