Is This Property a Good Investment?
(Royalty free image: https://www.pexels.com/photo/home-real-estate-106399/, Credit: Pexels / Binyamin Mellish)
The following is adapted from This Sh*t Works.
Imagine looking at a potential investment property as a private lender. You drive up to a house, a two-story Craftsman. It’s in a good neighborhood and has amazing street appeal. Despite needing a little work, you think anyone would be lucky to own it—but is it actually a good investment? How can you tell?
A property might seem like the perfect investment at first glance, but until you calculate the investment-to-value ratio (ITV), you can’t know for sure.
Fortunately, the ITV isn’t difficult to determine. All you need to know is the total loan amount and the property’s value after repairs, and you’ll have your answer.
Calculating the Investment-to-Value Ratio
The ITV is both critical to understanding the value of your deals and fairly easy to calculate. It’s simply the total loan amount, divided by that property’s total value after repairs.
Here’s an example: a property with an after-repaired value of $100,000 on which you agreed to loan the borrower a total of $75,000. That $75,000 incorporates both the acquisition cost and the additional money to renovate, for a total of $75,000. The investment to value ratio is 75 percent.
You can usually find the property value online. You could also have a good realtor broker on your team who will give you comparable sale values on this area so you can see price-per-square-foot sales figures, and number of days on the market (activity level). These figures can all help you ascertain the expected value of the property.
What you shouldn’t do is rely on the word of the borrower or the owner of the property. They’ll give you their assessment. That’s fine to start with, but you still want a verifiable and trustworthy estimate. Do your due diligence and ascertain the facts so you feel totally comfortable with the amount of money you lend on that deal.
Should You Invest in a Property?
You’ve calculated the ITV for your potential investment property. Now, how can you use that number to decide whether to invest or not?
The upper recommended threshold for lending is typically the range between 60 percent and 80 percent investment to value. How you look at it from your standpoint will depend on your risk tolerance and different aspects of the borrower and the actual collateral asset.
If your investment to value starts to creep above 75 percent, 80 percent, closer to 85 percent, 90 percent, what you’ve done is increase your risk, because now there’s very little margin at the top. The equity margin that you have above your investment is slim.
In private lending, you’re always looking at worst-case scenarios. They don’t happen very often if you do your due diligence, but you always want a margin of safety. For instance, 5 percent to 10 percent of equity above your loan is typically not enough to cover the potential cost of collection. You can no longer recoup your original principal, let alone your return on investment.
Therefore, ITV is very important for you as a lender. The higher you go, the riskier the investment.
How Much Risk Can You Tolerate?
To determine how much risk you want to take on, you want to consider several criteria. First, how well do you know the borrower? Have you done deals with him or her before?
If it’s your first time to do a deal with him, you might want to take less risk. Keep your investment to value down a little bit, down from 75 percent to maybe 65 percent or 60 percent, just to feel more comfortable.
Next, consider the property’s location. If you want to invest in an area that is a bit less appealing, lower your ITV. If it looks like a rock-solid deal and you have a rock-solid borrower with a track record in an area with conforming properties, you might go as high as 75 percent or 80 percent.
Lastly, be fully aware of your own financial comfort zone. If you’re just getting started, stick to a lower ITV. If you have more experience, and a track record with the borrower, bump it up if you feel so inclined. Just make sure you don’t risk too much and regret the decision later.
The Final Decision on a Property
As you can see, ITV is a useful tool for gauging the value of an investment and the risk involved when deciding whether to invest with a borrower. However, it is not a complete answer—you should look at all the factors together.
Consider the borrower themselves, the property, the neighbourhood, your own financial standing, and how much risk you’re willing to take on before deciding whether to invest or not.
There is no right or wrong; go with what fits your comfort zone. Just realize that these different variables that I’ve laid out are a big part of how you balance out your investment-to-value ratio, and use them to inform your decisions.
For more advice on real estate investing, you can find This Sh*t Works on Amazon.
Kent Clothier is the CEO of Real Estate Worldwide, a software training company for real estate investors, and the founder of the Boardroom Mastermind, the most elite real estate investor networking group in the country. He’s flipped thousands of homes over the past fifteen years and helped tens of thousands of people learn how to do the same. He is passionate about teaching what he’s learned in a simple way so that it’s easy for anyone to connect the dots. As a husband and the proud father of three amazing kids, Kent has built the ultimate life for himself and his family.