What do the terms Debt Service and Principle Reduction mean?

In Buying Property - Asked by Emmanuel D. - Feb 3, 2011
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Alex F.
Studio City, CA

Hey Emmanuel,
Debt Service is the total money that is paid out to a lender every year (or month). It can be interest only (it that is the term of the loan) or include both the interest and principle.
Principle reduction is the ammount of the loan that is outstanding. Suppose you originally had a loan for 1MM, and now the loan's total balance is 900k, your principle reduction is 100k.

Feb 3, 2011
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Rob B.
Chandler, AZ

Emmanuel....You may never totally understand the world of commercial real estate if you do not understand debt service and principal reduction. The real returns in real estate come from using prudent leverage in building a portfolio. Prudent leverage comes from borrowing enough money in a transaction from a financial institution, as the property will allow you to comfortably pay back. Your debt service factor will ideally allow you to have from 15% to 25% cash flow each month from your property after paying for the loan. To accomplish this you should purchase a property with the right cap rate. Then to be a wise investor you must borrow the 60%, 65%, 70%, etc of the purchase price at an interest rate that is at least 1% lower than you cap rate. What happens if you are able to achieve this is that you now have debt to "service". A part of that debt is the interest you are paying and another part is the contribution toward principal reduction. In most cases you are able for IRS purposes to consider the interest you pay as an expense against the property. (Not so when computing cap rates, as both interest and principal reduction are below the line in accounting for net operating income.). The amount you pay on principal each month "reduces" the amount you owe. Viola, at the time you sell the property you will owe less than you originally borrowed, so in effect this becomes a taxable event. This is a long explanation to your question, but if you truly study and practice the principals of Collected Income, less Operating Expenses, you will arrive at a Net Operating Income (NOI). From this NOI you will be able to see just how much you may be able to borrow. When you get your loan, you will then have the below the NOI line, Debt Service and Principal Reduction to deduct to get to "Cash on Cash". (There may be some reserve requirements that may also have to be set aside through the lender's edict that will fall below the NOI line as well, before reaching cash on cash.). Good luck Emmanuel..... Rob Baird, CA RE License #544165 (One of the oldest, active licenses in CA) 951 515-5855 Email: rob@capratecommercial.com

Feb 3, 2011
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Davide P.
Pinole, CA

Debt service is the mortgage payment. Principle reduction is the amount of money added to the value of the property (appreciation) due to paying off some of the principle of your loan.

Feb 4, 2011
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Steve B.
Houston, TX

Debt Service Coverage Ratio (D.S.C.R.) - The debt service coverage ratio, also referred to as the debt service ratio, measures the relationship between the amount of cash available to service the debt payments, which is the Net Operating Income, to the required debt payment to the lender.
This ratio is especially important to lenders. Their primary concern is your ability to service the outstanding debt, or in other words, your ability to make the payments. This ratio will vary among lenders, but a general range is from a minimum of 1.00 to a maximum of 1.35, with the most common ratio averaging about 1.20.
There are a number of factors that influence the lender's D.S.C.R. requirement including the age and condition of the property, the loan to value ratio, and your strength as a borrower.
While it is the lender who relies heavily on this ratio, it is equally important for you as the investor to understand its role in the financing equation. When you analyze a prospective property, you must be able to determine if there is adequate cash flow to service the debt. Without it, you'll never get a loan.
If the deal doesn't cash flow sufficiently to meet the D.S.C.R. requirements with a 20% to 30% down payment, chances are you'll want to take a pass on the deal and go on to the next one.
One final thought here. Please do not make the mistake of saying, "Oh, I'll just put more money down to lower my monthly payments." It is true, that would help to bring your D.S.C.R. in line, but guess what? By putting more money down, you are reducing the cash on cash returns, as well as the total R.O.I.s. An investor's primary goal is typically to maximize the return on investment, so the lower the initial equity and/or cash investment, the higher the R.O.I. will be.
As loans are amortized over a period of years, there are two parts of every payment - interest and principle. The payment amount can be 100% interest and 0% principle (as in an interest only term loan with a balloon), or it can be a more traditional loan repayment structure similar to what exists in residential loans with the amount of interest paid each month declining over time while the amount of the principle (the actual amount of the loan dollars borrowed) being repaid each month increases.
FYI - There are dynamic real estate investment software models that allow the user to see these ratios and their effects on cash flow by simply changing a few key variables.
Hope this helps!
Steve Berges - Author

Feb 5, 2011
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