It is sometimes alarming how little understood real estate investments can be. With increasing regularity people are making decisions to engage in debt-financing from the bank to buy real estate investments in Japan, commonly Tokyo, that run into hundreds of millions of yen. This is a fantastic situation for real estate brokers and banks. Unfortunately, your interests may not always be aligned. As the real estate agent who brokers the transaction is paid on conclusion of the sale, you will seldom hear any pearls of wisdom from them which may steer you away from the decision to “buy”. Before making a real estate investment you should consult with your financial planner who will be able to put the potential real estate investment into context, just like any other investment; i.e. what affect would it have on your overall finances, your tax liabilities, tax breaks, ownership considerations, risk, correlation to other investments, diversification affect and real ROI.
professional investors will look at investments differently to retail investors. This should not come as a surprise. The chef at an expensive restaurant will improbably prepare a meal in the same was as you or I- hence why we are willing to pay a premium to taste their expertise. DCSR, as it is often called, stands for Debt Service Coverage Ratio. If the word “debt” sends a shiver down your spine then you are in the right place- especially if you are considering a real estate investment financed using the bank’s money. We all know what happens when you can’t pay your debts…
When you take an investment property proposal to your bank manager, they will likely ask you for a series of documents (rent-roll, tear sheet, value appraisal etc.) and tell you that they will get back to you in a number of weeks with a decision on whether or not they are willing to lend on it, and if so, how much. It is highly probable that DSCR will be one of the calculations that they use in the underwriting process. In short the DSCR is is the net operating income divided by total debt service cost.
NOTE: To approve your loan, the bank will likely require a DCSR of 1.15 or above.
So what does this mean? Lets imagine that Net Operating Income (NOI) is 3,000,000 JPY a year and the total debt service is 2,000,000 JPY per year. In this case the DSCR would be 3,000,000/2,000,000, which equals 1.5. This may sometimes be shown as 1.5x, indicating that NOI covers debt service 1.5 times over. Would the bank be happy? Yes. Probably.
In short, the DSCR metric illustrates the degree of coverage offered by the cash-flow to cover the debt owed on the project. Where you have to be careful, is in calculating your NOI….
Problems with calculating your net operating income and net rate of return…
Where do we start? The difference between the “gross” and the “net” is the amount which has to be spent/paid away throughout the year, leaving our remaining real (gross) profit at the end. With a property investment there are many moving credits and debits throughout the year and as such we have to take a multi-factor approach to calculating the NOI. The problem with this, is that our methodology may be different to yours, and yours to someone elses. In short, we may include or exclude certain expenses. We may not even acknowledge certain expenses altogether. There is no correct method, only degrees of conservatism. For example:
annual ownership taxes: Fixed Asset Tax at 1.4% p.a, City Planning Tax at 0.3% p.a
income taxes: marginal, from from 5% to 45%
‘Useful life’ ranging from 3 years to 50 years (dependent on construction and classification)
repair and maintenance: estimated to be 3% of purchase price p.a
property management company: ordinary fees between 5% to 8% of rental income generated
Having a skilled accountant can make or break a real estate investment in Japan. Many of the costs and fees involved are deductible for tax purposes, allowing you to reduce your taxable base and bank more net income. The question is, to what extent do you incorporate these “miscellaneous” expenses into your DSCR calculation. Afterall, on a monthly basis for example, your cash flow will not be affected by annual property taxes. They will not affect your monthly ability to meet loan repayments. However, when the annul tax bill arrives if you are unable to pay it then you encounter a solvency issue. Although the bank will have been appeased, you still need to find the money to cover the costs and taxes of the investment, and if the investment does not provide enough surplus income to cover these, then free cash flow is in fact negative, and money must be paid from out of pocket.
Another example would be the cost of having the property managed by an agent. Gross monthly income is usually charged at 5%-8% each month and the proceeds sent to the owner net of this charge. This net payment is the NOI. The lower the NOI, the lower the coverage shown by the DSCR formula. However, if the investor is able to use this expense to reduce his tax liability, and secure a tax rebate as a result, despite the frequency of this credit being received being annually as opposed to monthly, is this not relevant to the ability of the investment to cover its costs? The notion here is similar to that of valuing a stock. Depending on the methodology used, different results will be arrived at. There is no definitively correct answer.
In this manner, DSCR calculations can become elaborate if need be. You can choose to, based on your own circumstances, include certain credits or debits which will affect the free cash flow of the investment- increasing or decreasing the debt service coverage ratio. Before getting to this point, a lot of unnecessary work can be spared if you first focus on the affect of vacancy, which is the largest determinant of debt coverage and has the potential to stop an investment dead in its tracks.
Real Estate Investment Vacancy And DSCR
Let us imagine that Mrs. Smith has bought a 6 room residential apartment building in Chiba as a long-term investment, limiting our observation to vacancy alone, ignoring all of the other variables mentioned previously. We will also work on the premise that all rooms are the same size and command the same rent. She has paid 60,000,000 JPY for the building (again, ignoring closing costs, commissions etc.). The gross yield of the building at full occupancy is 7.2% p.a. She has secured financing from the bank on a 30 year loan term, with a fixed rate of 1.4% for the first 10 years. Accordingly, for the first 10 years we can take a simplified view of the DSCR as follows:
Total cost: 60,000,000 JPY
Down payment: 16,000,000 JPY
Loan amount: 44,000,000 JY
Gross annual cash flow: 4,320,000 JPY
Purchase price gross yield p.a: 7.20%
The investment provides sufficient coverage of the monthly repayments right down to 50% vacancy. This means that 3 of the 6 tenants could move out and the building would still produce sufficient free cash flow to pay back the bank and ensure that Mrs. Smith does not have to pay money out of pocket. This is a good starting point for exploration. However, it may be prudent to consider that the monthly loan repayments are fixed for 10 years, and as such we should take a holistic view of this risk period. For example, what do the numbers look like if we assume that there will be 3 years with full occupancy, 3 years with 83% occupancy, 3 years with 66% vacancy and 1 years with 33% occupancy.
Using the debt service cover ratio is a good way to get a quick litmus reading of a real estate investment. It can be used as a multi-factor approach and scaled up as required, encompassing different time periods, cash flows, properties and debt obligations. Improve your investment prospects immediately by looking at your Japanese real estate investment portfolio in the same way that the bank does.
[ Sources ]
– Decision theory and real estate investment: an analysis of the decision-making processes of real estate investment fund managers, Nick French, 2001
– Modern Investment Theory and Real Estate Analysis, P.E Penny, 1980
– The Japanese Real Estate Investment Market 2016, Nomura Research Institute