Debt-to-Equity Ratio: What Is It & How To Calculate

It’s not always easy to know if an investment property is a good addition to your portfolio. The property might be in excellent condition, and it might even bring in extra income and boost your cash flow each month. However, that doesn’t necessarily mean it’s worth the long-term debt or that you’ll see a positive return on investment.

That’s where the concept of debt-to-equity ratio comes into the picture. The debt-to-equity ratio provides a clear picture of how much total debt an investment property comes with compared to its equity. A higher debt-to-equity ratio means taking on a higher risk with the investment, so the idea is to look for options with low debt-to-equity ratios.

Today, we’ll dive a little deeper into what the debt-to-ratio is, what is considered a good debt-to-equity ratio, and how you can use this formula to determine the potential for future investments. With Vaster, you can also use the debt-to-equity ratio to learn whether a cash-out refinance or purchase is right for your long-term goals.

Understanding Key Financial Terms in Real Estate

Before we proceed, let’s break down a few key terms: equity, liquidity, and liability.

Equity

Equity is the difference between what you owe on your property and what the property is currently worth.

This percentage represents how much of an asset you own. If you buy a property outright, it’s 100% yours. If you use a loan to make the purchase, you’ll slowly generate equity with each payment.

Let’s say you have a real estate investment property worth $500,000. If you’ve paid $300,000 toward the mortgage loan, you would have 60% equity in the property.

Liquidity

Liquidity is often confused with equity as they’re closely related. However, there is a key difference between the two.

Equity represents the total amount of the asset you own outright. Liquidity refers to how quickly you can convert that asset into cash. In other words, just because you have $300,000 of equity in your property doesn't mean you have $300,000 in the bank. As an investment property, liquidity isn’t as important as equity, but it’s worth knowing the difference.

Liability

A liability is defined as anything that you might owe. For example, mortgages, student loans, and your monthly bills are all examples of your current liabilities.

Ideally, you should aim for more equity and total assets with less debt and fewer total liabilities. When it comes to an investment property, it can take a little while to work down the liabilities and debt, which is why understanding the debt-to-equity ratio is so important.

Debt-to-Equity Ratio and its Impact on Real Estate Financing

In real estate, the debt-to-equity ratio or DTE ratio is a measure of an investment property's total liabilities compared to its current equity. In other words, this financial ratio demonstrates the relative amount of debt that a company or person has. You can calculate this leverage ratio with the following template:

Debt-to-equity ratio = mortgage balance / equity

Let’s take a look at an example of the debt-to-equity ratio formula.

Say that you purchase a new investment property worth $750,000. You make a $250,000 down payment, so you have $250,000 in equity and $500,000 in debt. Plug those numbers into the DTE formula, and you get:

$500,000 / $250,000 = 2

Your debt-to-equity ratio is 2. Put another way, you owe $2 for every $1 you own or “have” in the property.

So, what is a good debt-to-equity ratio? Generally, an ideal debt-to-equity ratio in real estate and other capital-intensive sectors is 2.33 or so, meaning you have 70% debt and 30% equity. It’s usually advisable not to invest in any property with a debt-to-equity ratio of 5.5 or more — a higher debt-to-equity ratio than that, and you’ll take on a greater financial risk by purchasing the property.

A low debt-to-equity ratio is always ideal and should be the primary goal when looking for investment properties. A high debt-to-equity ratio is never a good thing, as the risk of losing money on the deal is more likely, especially in an economic downturn. However, remember that the current ratio isn’t set in stone. Paying down a mortgage and increasing the value of the property can help lower this ratio.

Introduction to Cash-Out Refinances in Real Estate

A cash-out refinance is a process where you take out a new mortgage on the property you already own for more than your property’s current value. This is where the concept of liquidity comes into play. By turning your equity into liquidity, you can pay off your old mortgage with the new mortgage total, then pocket the difference in equity for whatever purpose you have in mind.

Many property owners use cash-out refinances for renovations, new home purchases, and paying off debt. Making renovations to the property can increase short-term debt, but it can also lower the debt-to-equity ratio as the value of the property will also increase. The debt-to-equity ratio can impact whether or not you are eligible for a cash-out refinance from your favorite lender, like a bank or credit union.

In addition, it'll affect whether you have a high or low interest rate. The better your DTE ratio, the lower your interest rate will be and the lower you'll pay for your cash-out refinance loan over its term. You should, therefore, use the D-to-E ratio for your debt financing strategies.

Calculating How Much You Can Cash Out in a Refinance

Just how much you can cash out in a refinance depends on factors like:

Your credit score
Your DTE ratio
Your new loan’s proposed total

Remember, your "cash out" value is based on how much equity you've built up in the property and the new total for the cash-out loan you want to receive. For example, say that you want to do a cash-out refinance for a property you own that’s worth $500,000. You currently have $250,000 in equity for that property.

Given your high credit score and low DTE ratio (a ratio of 1 — to calculate this, divide 250,000 x 250,000), a lender is willing to underwrite a loan for $750,000.

You take out the loan. You use the $750,000 to pay off your current remaining mortgage balance, so you have $500,000 left. This is a very basic example of a refinance, so it might not reflect a real deal you’ll make in the future, but it illustrates how you can use your equity to “cash out” and make a significant profit.

Navigating Debt-to-Equity Ratios and Cash-Out Refinances in Changing Markets

This all said, your debt-to-equity ratio — and your qualifications for cash-out refinances — are also dependent on the current market.

If the market is in a downward trend and property values are plummeting, it may not be the wisest idea to refinance. Why? Your property's value could decline as you search for the ideal loan and lender.

However, you can always improve your debt-to-equity ratio by making aggressive payments toward your current mortgage balance and improving your property. If you make home renovations or other upgrades that improve your property’s value in equity, you’ll directly improve your DTE ratio by maximizing the equity side of the equation.

Leveraging Debt-to-Equity Ratio for Successful Real Estate Investments

To get the most bang for your buck and maximize the return on your investment, you'll want to do everything you can to use the DTE ratio as an investment strategy.

For example, you can directly improve your property to increase its equity. You can also make more payments toward the principle of your existing mortgage, thereby improving your DTE ratio in the most common way.

However, remember to try to avoid high debt-to-equity ratios as much as possible. High DTE ratios make it hard to qualify for new loans and cash-out refinances across the board. To do this, pay down mortgage principals as aggressively as possible. You should also avoid taking out mortgage loans without making reasonably sized down payments.

The Takeaway

All in all, the debt-to-equity ratio is an important tool you can use both to estimate the value you get from a cash-out refinance and to determine whether an investment property is a good idea. If you’re already a real estate investor or property owner, you should monitor your DTE ratio whenever possible — it will tell you the health of your portfolio better than many other tools.

Remember, a lower debt-to-equity ratio makes a cash-out refinance offer or purchase offer more attractive to lenders. If your DTE ratio isn’t yet low enough, doing everything you can to lower that ratio is a good way to get better terms for an upcoming refinance or mortgage loan.

To better manage your business's financial health, consider Vaster's expertise. Explore our services, or apply for a purchase or refinance option today.

Sources:

Debt-to-Equity (D/E) Ratio Formula and How to Interpret It | Investopedia

Why Is Liquidity Important In the Real Estate Industry? | LinkedIn

Cash Out Refinance vs Home Equity Line of Credit | Bank of America

Home Equity: What It Is, How It Works, and How You Can Use It | Investopedia