For those who have taken my apartments class, you know the importance of DSCR (Debt Service Coverage Ratio). The formula for DSCR is as follows.

Property's Total Annual Income (Assume Full Occupancy)
minus Property's Total Annual Expenses (Include Vacancy, Taxes, Insurance :Do Not Include Debt Service)
equals NOI (Net Operating Income) Banks refer to this as FUNDS TO SERVICE DEBT

NOI divided by the annual debt service (Principal and Interest Payments) = DSCR

This formula allows lenders to determine if the property will generate enough income to service the debt. A DSCR of 1 is a break even at best. Anything below 1 means the buyer is going to have negative cash flow. Is it any wonder lenders want a DSCR of 1.25 to feel secure

For example, if a property has a NOI of $50,000, and annual debt service of $50,000 (P+I), this would be a break even. In other words, a DSCR of 1, which is not a good situation to be lending money on. If there is an added expense the property will not support itself. This means one of three things will happen;
1. the buyer is going to have to dig into his/her pocket,
2. not fix the problem (more vacancies),
3.or not be able to make the note payment.

By the same token, let's look at a property with a NOI of $50,000 and a debt service of $40,000. If we divide $50,000 by $40,000, we come up with a DSCR of 1.25. In this situation, there is room for unexpected expenses, and still have money to pay the debt service.

If you sell your property using owner financing, you should use a DSCR as a criteria also. You do not want to sell your property where the odds are great the buyer will not be able to make his payments. Make your note accordingly.

A case in point. A note seller brought me a note where the payor put very little down. The seller inflated the price of his 8 unit apartment. Now to add to his problem, he charged 12% interest. To continue with case study, with a NOI of $50,000, the debt service was a whopping $55,000. The seller was flabbergasted when I explained to him that this was a foreclosure in embryo.

"Are you receiving payments regularly?", I asked. "He has always been a month late. But he always pays", was the reply. The seller just now realized his buyer was late because it took him two months to get enough money to make one month's payment. It then came to light that there were now three vacancies. We did not even get into deferred maintenance. The next step is default. I suggested he immediately get with his buyer and recast his note.

Had the seller known about DSCR, he would have known his buyer would not be able to make his payments. Note buyers will also look strongly on DSCR. Next to having root canal work done, taking back a property with high vacancy, with deferred maintenance is my least favorite pastime.

Here are some Do's and Don'ts when selling your apartments or commercial property.

1. Be sure to get credit information on your buyers. (Even if they are an LLC or a corporation)
2. If an LLC or corporation, have your buyers sign a personal guaranty for the note. This is often a separate document. Although gurus will tout non recourse and no guaranty, if you want to sell your note, your buyers are going to have to be personally liable on the note.
3. Be sure to have "assignment of rent" clauses. If your buyer stops paying, you want the authority to collect rents to pay you off.
4. Demand 20% or more down. (If you want to sell your note)
5. If you inflate your property's value, do not inflate the interest and terms also. The inflated price is "interest" enough. Make the note easy to pay. You might have difficulty in selling your note at an inflated property value, but you will enjoy a long, healthy cash flow. (Be careful of imputed interest. Ask your accountant)
6. Look at your buyer's DSCR. If it is not 1.25 or more, chance are you are going to be taking the property back at some point. If the DSCR is in line, you definitely going to get a better price than a break even DSCR.
7. Remember, just like residential notes, the more down payment you get, the more money in your pocket. Low down payment, low credit scores and low DSCR will not translate into selling your note. In fact, any one of these translates into a future default.
8. In your contract, separate the price of the building, the land, furniture and goodwill. This will keep the note buyer from having to "guess". When we have to "guess", guess whose side we favor? Guess whose side the IRS favors?

These are just a few tips on owner financing your commercial property. Feel free to contact me if you are selling your property using owner financing. We can go more into detail on how to achieve your goals and avoid traps.

Tom will be covering this topic in detail on his March 3rd Workshop. Sign Up Early to be assured a seat.

If you have any questions or comments, be sure to contact me In the subject line, write ASK the PROFESSOR. I will try to answer your questions in the next Note Professor issue.

Remember, if you know of someone who has a note to sell, I will pay referral fees at the least, and will also split my profits if you would like to "co broker" a Note with me.

To forward this email to friends or business associates who have an interest in real estate, click the "forward button" at the very bottom of this newsletter

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Tom Henderson /a.k.a. THE NOTE PROFESSOR .

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By popular demand, THE NOTE PROFESSOR NOTEBOOK is now available in easy, downloadable E- book form for a the low, affordable price of $39.95. Other products are also available, including HOW TO MAKE OBSCENE PROFITS with SMALL MONEY, and GUIDE FOR SECOND LIENS. There is also a FREE download of CHECK LIST FOR OWNER FINANCING. Simply go to the NOTE BUYERS STORE. I can think of nowhere that you can find such information packed products at such incredibly low prices. We are still working out the bugs, so if you have any problems, be sure to contact me.

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I had a couple or questions regarding the economy last week. Rather than address the questions here, I want to point out that in both questions there was confusion and errors in their definition of "demand". I thought a revisit of definitions would be in order. When we understand the true definition, we will soon begin to see how our politicians distort the meaning of demand, and therefore the concept of demand, and equate desire with production. No wonder we are in the situation we are in.

DEMAND: The willingness and ability of the people within a market area to purchase particular amounts of a good or service at a variety of alternative prices during a specified time period.

Another Definition: The want or desire to possess a good or service with the necessary goods, services, or financial instruments necessary to make a legal transaction for those goods or services.

I picked these definitions randomly from economic dictionaries. Separately, neither quite explains the concept of demand, but if you combine the two, you will find the most complete definition of "demand" I have time for in this issue.

The first point to notice is that mere want or desire is not the ultimate element of demand. There must also be a willingness, (I use the term "voluntary") as well as the ability to exchange goods or services for what we want. What about "the financial instruments"? In another issue I will delve into the concept of money, but for this issue, suffice it to say that money is merely a representation of goods or services. Is this not why we work or invest; to obtain goods and services we desire not only to survive, but also to prosper. In essence when we go to work, we are exchanging our services for other goods and services that money is suppose to represent.

Think of what the phrases "with the necessary goods, services, or financial instruments" means. An example from a real estate point of view, means you will trade a person a place to live in exchange for "financial instruments", which you will exchange for goods and services you desire. Your renter also worked to exchange his/her services for "financial instruments" to pay you rent for a place to shelter him/her from the elements. This is the essence of division of labor, and what makes a free market system function. Demand and production go hand in hand. In other words, without the ability to produce there is nothing to exchange; and therefore no demand.

Next notice in the definitions "purchase at a variety of alternative prices" What this means is for there to be a "demand" there must be a price system. In other words, you will exchange apple for an orange, but you might want two bananas for one apple because of your preference. You, the individual, will decide what "price" to put on an orange or a banana. To put it another way, we produce in order to consume. More importantly, we cannot consume unless we produce. Consumption cannot exceed production.

For the economic concept of demand to function, there must be a price system by which individuals determine what we want, and how much of it, or in other words, what to produce and how much. As a side note, socialism cannot sustain itself because there is no price system. Socialists have the false belief that production will just happen and desire alone is the only requisite for the concept of demand, and completely ignore the other part of the equation for demand, which is producing goods or services to exchange.

I am addressing the concept of demand because of a question I received wanting to know if Congress "gave" banks money, as well as individuals, would this not increase demand. The answer is "NO"!!!! To begin, what did Congress exchange for the money they are "giving"? Nothing. They merely took it out of "productive pockets" and redistributed it into non productive pockets. Not only did Congress produce nothing in exchange for our production, the recipient of our money exchanged nothing to us to receive our money. . This is a form of consuming without producing. As the definition of demand tells us, demand requires willingness, and production for there to be an exchange. How can demand increase when there was no voluntary exchange of goods or services?

You will often hear media pundits and politicians incorrectly state that our economy is based on consumer demand. What they omit is "consumer demand" is based on individuals producing in order to exchange goods or services. They imply that all that is needed is to "give" them our money, and in turn this will increase demand. As we have learned this is a false economic premise. The concept of demand also embraces individuals to produce something in exchange. This is the essence of any economy and the cornerstone of free markets. Consumption alone does not create demand, it only depletes resources.

We also hear the phrase, "the demand for money". Knowing the definition of "demand", what does this imply? HINT: What goods or services are exchanged for money? When money is printed from thin air, is this the same as production, or is it a form of consuming without producing. Food for thought. Bon Appetite.



If you have questions, CONTACT ME. I will address them in future issues.

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