Intro

SPEAKER_00 0:05

Welcome to the 5 Minute Prime Podcast. Quick actionable tips to master personal finance and real estate investing. In just five minutes a day, we'll help you build wealth and achieve financial freedom. Hey Prime Investors, Martin Maxwell here. Welcome back to the 5-Minute Prime Podcast.

The deal

SPEAKER_00 0:24

A tenanted single family rental comes across your desk. Listed two weeks ago. Nothing exotic about it at all. No deferred maintenance. Tenant in place with nine months left on the lease, and the rent is verifiable, which is rarer than it sounds. You are not taking anybody's word for it because somebody is already paying it every month. That matters more than people give it credit for. Most of diligence is arguing with yourself about whether a number is real. With a signed lease, that argument is over before you start. You have got your financing lined up to a DSCR program, debt service coverage ratio, the test a lender uses to decide how big a loan the rent can carry. Minimum coverage of 1.20. Maximum loan to value of 75%. Here are the numbers. Asking price $240,000. Rent $2,000 a month. Run operating expenses at half of gross rent, the standard first pass. And your net operating income is $12,000 a year. $12,000 on $240,000. That is a 5% cap rate. What the building earns on its own before any loan. You have $75,000 in cash, your note rate is 6.85%, which on a 30-year loan gives a loan constant of about 7.86%. The rate plus the principal you pay back each month. Nothing here is a surprise. You have underwritten a dozen of these.

01 · The lender’s answer

SPEAKER_00 1:50

So you send it over, and the number comes back smaller than you expected. The 75% loan to value ceiling would have allowed $180,000. That is the number you had in your head. But that is not the constraint that binds. The coverage test is. 1.20 times the loan constant divided into your net operating income. And that lands at about $127,000. $53,000 lower than the loan to value ceiling. On the same house from the same lender on the same day. And I want you to sit with which one of those two tests is binding. Because it tells you something the number alone does not. Loan to value is a test about the property. It asks what the thing is worth and lends a fraction of it. Coverage is a test about the income. It asks what the thing earns and lends whatever that income can safely carry. When loan to value binds, your problem is the down payment. You need more cash to close the gap. When coverage binds, your problem is the rent. And no amount of cash you put down changes the rent. That is why this particular gap does not behave the way people expect. It looks like a cash problem. It is an income problem wearing a cash problem's clothes. Add your $75,000 in cash. You can bring a little over $202,000 to this closing. The asking price is $240. You are just under $38,000 short. And here is the number that should stop you. At the asking price, on the loan you would actually need, the coverage on this deal works out to 0.925. Not $1.2, not even $1.0.

02 · Three options

SPEAKER_00 3:31

So three options. Hit pause, decide, then come back. Option one, offer what your program funds. About $202,000. It is the honest ceiling of what you can bring. The number is defensible, and if the seller says no, you have lost an afternoon. Option two, recognize you are not the buyer this is priced for and move on. Say so plainly in your offer notes. Option three, restructure until it funds. More cash down until the coverage test passes, or ask the seller to carry a second behind the bank. Same house, different capital stack.

03 · The breakdown

SPEAKER_00 4:08

Start with what that $38,000 actually is. Because almost everybody gets this backwards. It is not a measure of how overpriced the house is. Nobody has appraised anything. It is the distance between one seller's asking price and the ceiling of one financing program. Change the program and the gap moves while the house sits there unchanged. A cash buyer has no ceiling here at all. Neither does a 1031 buyer, someone who sold another property and has 45 days to name the next one or owe tax on the gain. Put 150,000 of gain on that clock and paying above your ceiling is rational because their alternative is a tax bill. Neither of those people is wrong to pay this price. You are being told no by your capital structure, not by the market. And if you have already bought at a number a lender handed you, plenty of very good investors have, this is not me saying you got taken. It is a narrower point. Which number you let set the price on the next one. Earlier this week, I made the case that a market clearing your screen is not evidence you found something. Same shape here, one step later. There the test was a screen, here it is a lender's. Which brings me to option one. And I want to be careful here because it is the most reasonable sounding of the three. Offering the number your program funds means pricing your offer to a coverage ratio. And a coverage ratio is the lender's covenant, the number that protects their position if this goes wrong. Price to it, and you have handed the pricing decision to somebody whose job is not to get you a return. And it barely helps. Drop the price to 200 and 2,000, and the cap rate does move. Same 12,000 of income over a smaller number. So you are at 5.94. Better, still under 6.85% money. Option 3 deserves more respect than it usually gets. More cash genuinely does make this fundable. Put about $113,000 down and the coverage test passes. But look at what you bought. Debt Service runs about $10,000 a year against $12,000 of income. You clear roughly $2,000 on $113,000 of your own cash. About 1.8%. Against a 5% cap rate. Your cash on cash, the return on the cash you actually put in, lands below what the building earns on itself. That is the cash clock, and it is red. Notice what it is not. Nothing is bleeding. The property pays you. You just wrote a very large check to earn less than the asset earns unlevered. And the other clock, the wealth one, is red for a simpler reason. A 5% cap against a 6.85% note means the money costs more than the asset returns. That is true before leverage enters at all. Passing the lender's test never had a chance of fixing

Earn the walk-away

SPEAKER_00 7:02

it. Take option two. But earn it first, because there are two calls to make before you walk. 1.20 is this lender's covenant, not a law. Other DSCR programs run lower floors. And the thing capping your loan is the loan constant. So ask whether the seller will fund a rate buy down or carry a second behind the bank. A lower rate lifts the loan the same rent can carry. Run both and the gap closes from $38,000 to about 19. Real money and still not enough. The answer holds, but now it holds because you checked. And that is the finding. Not a shrug, here is your challenge today. Write one sentence in your notes on this listing. At a 5% cap, this price needs a buyer with cheaper money than mine or a deadline worse than mine. That sentence is worth more than the listing was. Because the next time a five cap tenanted rental crosses your desk, you will know in 90 seconds instead of a week. And you will know exactly which question to ask first. And the rule underneath all of it, ask what question a number answers. A maximum loan answers how much this lender will advance against this income. It has never once answered what this house is worth. The full write up, all three options side by side, with the arithmetic laid out, is linked right there in the show notes. I'm Martin Maxwell. This has been the Five Minute Prime Podcast. I'll see you next episode.