What Is a Good Debt to Equity Ratio for Real Estate Investors?
August 22, 2022
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Debt to most people is bad, right? In the real estate investing industry, however, debt can be helpful. For example, mortgage lenders help investors leverage their investments to allow more significant investments than they have in free capital.
When considering leveraging your investment with a mortgage, it's crucial to understand how to calculate the debt-to-equity ratio for real estate.
What Is a Debt-to-Equity Ratio
The debt-to-equity ratio for real estate measures the debt outstanding on your home to your equity. From an investor's standpoint, it's the amount of debt owed for every dollar of equity. The higher debt to equity ratios are, the more risk a lender takes because there's less 'skin in the game.'
Consider it a measure of how much debt you have compared to how much you own. The more an investor owns, the less likely he is to stop making mortgage payments if the real estate market has trouble. A good debt-to-equity ratio may differ by the investor, though.
What Does the Debt-to-Equity Ratio Tell Us
The debt-to-equity ratio is a financial ratio that tells lenders and investors a lot about the investment. It's a measure of ownership and riskiness that lenders and investors can use to make investment decisions.
High Debt-to-Equity Ratio
A high debt-to-equity ratio means there is a lot of debt compared to equity in the property. Lenders consider this risky because a real estate investor doesn't have a lot of 'skin in the game.' In other words, the lender has more at stake than the investor. This could make it more challenging to secure purchase financing or refinance existing properties.
Low Debt-to-Equity Ratio
A low debt-to-equity ratio means a real estate investor has more invested in the property than they owe. This is a low risk for lenders because investors have more to lose than lenders. Tapping into the home's equity or refinancing for better terms is more accessible with low debt-to-equity ratios.
How to Calculate Debt-to-Equity Ratio
To calculate the debt-to-equity ratio, you must know the outstanding loan amount and the property equity and use the debt-to-equity ratio formula.
Here's how to find debt-to-equity ratio:
Mortgage loan balance/Property equity = Debt-to-equity ratio
Here's an example:
You purchase a property for $300,000, making a $75,000 down payment. You have $225,000 in debt and $75,000 in equity. Calculating the debt-to-equity ratio looks like this:
$225,000/$75,000 = 3.0
This means for every $1 you own in the home, you owe $3.
Debt-to-Equity Ratio Calculator
You can calculate properties' debt-to-equity ratios using the debt-to-equity ratio formula or find a debt-to-equity ratio calculator online to make faster decisions. This is especially helpful if you're considering a portfolio of properties or investing in a passive income real estate investment, such as a real estate investment trust.
What Is a Good Debt-to-Equity Ratio for Real Estate Investors
An excellent debt-to-equity ratio somewhat varies by investor. It also depends on whose perspective you're looking at it from.
Lenders, for example, want a low ratio. The lower the ratio, the more investment you have in the property. This lowers a lender's risk of losing everything. For example, if you invest in a property with a 10% down payment and property values decrease, leaving you with little to no equity, what stops you from throwing the keys on the counter and walking away from the property?
On the other hand, if you have more money invested, say 25%, you have more skin in the game, aka more to lose. Therefore, you are less likely to walk away from the investment even if values fall.
Investors' Debt to Ratio: Change Over Time
Debt-to-equity ratios can change over time as the real estate market changes. In addition, your mortgage repayment patterns also affect the debt-to-equity ratios. As you pay your mortgage balance down, you have less debt and more equity.
How Does Debt-to-Equity Ratio Decreases Over Time
Most debt-to-equity ratios decrease over time because real estate appreciates and mortgage balances decrease with regular payments.
Say, for example, you bought a home for $200,000 two years ago. The average appreciation over the last two years is 18%, so today, the property is worth $236,000. When you bought the home, you made a $40,000 down payment.
When you bought the home, your debt-to-equity ratio was $160,000/$40,000 = 4.
Today, the home is worth more. At this point, you owe $155,300 on your mortgage. Your ratio low looks like this:
$155,300/$80,700 = 1.92
This is a much lower risk for lenders.
How Can a Debt-to-Equity Ratio Increase Over Time
Like any investment, the real estate industry can decline too, causing real estate investors to lose money. In the long term, properties appreciate, but there could be hills and valleys along the way. This can cause a debt-to-equity ratio to increase.
For example, say you bought an investment property for $200,000, investing only 15% in the property. However, you did your research, and the area has appreciated regularly, so you felt comfortable leveraging your real estate investment with long-term debt.
Unfortunately, the real estate industry had trouble in the area you invested in, and homes lost an average of 15% over the last couple of years.
When you bought the property, your debt-to-equity ratio was:
$170,000/$30,000 = 5.6
After the decline, though, your ratio increased to the following:
$162,440/$7,560 = 22.4
Why an Investor May Increase Their Debt-to-Equity Ratio?
Real estate investors may want to increase their debt-to-equity ratio in certain situations. This is the case when they can improve their return on equity.
The return on equity is a ratio of property cash flow to property equity. The higher the return on equity, the better the investment.
For example, if you own a property with a 1.0 debt-to-equity ratio, you own just as much as you owe. Let's say you earn $10,000 a year in cash flow, and your equity in the property is $100,000 (it's a $200,000 property).
Your return on equity is:
$10,000/$100,000 = 10%
If you pull money out of the home's equity to increase your real estate portfolio and buy more properties, you increase your debt and decrease your equity. For example, the higher debt decreases your cash flow to $8,000 and your equity to $35,000.
Your return on equity increases to:
$8,000/$35,000 = 22%
However, your debt-to-equity ratio increases to 4.7 versus 1.0.
Good Debt-to-Equity Ratio FAQ
Do You Want a High or Low Debt-to-Equity Ratio?
Each real estate investor has a different threshold for financial risk. A high debt-to-equity ratio puts the lender and investor at higher risk. If the industry declines, the lender and investor have a lot at stake (and a lot to lose).
Some investors prefer the higher risk because there's more reward. Others prefer a lower ratio of debt-to-equity for reduced risk and average returns.
Lenders Generally Prefer a Debt-to-Equity Ratio That Is?
Most mortgage lenders prefer a ratio of 2.0 when comparing debt to equity, but this can vary. Like mortgage guidelines, all lenders have different requirements. Some will take more chances than others, like investors have different risk tolerances.
What Is the Average Debt-to-Equity Ratio for Investors?
The average ratio for debt-to-equity for real estate investors is around 2.0, which is what lenders prefer. This gives investors the highest chance of loan approval; however, some investors have much higher or much lower ratios based on their risk tolerance and preferences.
What Is Considered a Healthy Debt-to-Equity Ratio for Investors?
A healthy ratio when comparing debt-to-equity is 3.0 for investors. This gives investors the chance to leverage their debt with a mortgage but not be so far in debt that they'd be at risk if property values decreased.
The Debt-to-Equity Ratio for Investors: The Bottom Line
It is important to understand how the debt-to-equity ratio for real estate works and how to compare it to your investment. The ratio can help you make important investment decisions as you do your due diligence to determine if a real estate investment is worth it. Learn more by signing up and visiting our blog.
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