Seller financing is when a seller is willing to sell you an asset and to accept a mortgage (IOU) at the point of sale instead of receiving cash at closing for their property. The amount of loan to value (LTV) the seller is willing to accept is negotiated per deal.
Get my Creative Financing Calculator HERE!
With seller financing the seller will replace the bank. You will most likely need to put some amount of money down at closing.
Now let’s look at the basic formula (income approach) for analyzing a real estate deal.
Income (rent) – Expenses = Net Operating Income (NOI)
NOI – Debt Service (mortgage payment) = Cash Flow.
This is the basic math to determine if a deal will cash flow. If you want to know what the return on investment (ROI) is created by the cash flow that is called cash on cash return and it is-
Cash Flow / Total Acquisition Cost
Total acquisition cost is the downpayment plus any other money brought to the deal at closing (for renovations, repairs, etc.). Using this seller financing calculator below.
NOI ≥ Debt Service
That’s it. You don’t need some sort of fancy seller financing calculator to do this math. Look at it this way. You are on a debt budget. What is your budget? The total net operating income of the property.
Debt Service Coverage Ratio (DSCR)
NOI / Annual Debt Service
This is the next thing to consider when doing the math on a seller financing deal. This is the real calculator I promised you. You can spend the entire NOI of the deal on the mortgage payments. If you do this the math would look like this.
NOI / Annual Debt Service = 1.0
This is called debt service coverage ratio (DSCR). A traditional lender will typically want to see a DSCR of about 1.25%. This means that for every $1 of annual debt payment the lender wants to see that the property is producing $1.25 in net operating income.
Now when we apply this concept to seller financing, we do not have any DSCR constraints. You can do whatever you want. That is why gave you this seller financing calculator-
NOI ≥ Debt Service
This is also why I describe the analysis to be a “budget”. You have the entire NOI to “spend” on the annual mortgage payment to the seller. If you spend more than that amount your DSCR will be less than 1.0 and you will have negative cash flow. Not good.
Use this concept when trying to negotiate a seller financing deal. When the seller asks for a certain down payment or a certain interest rate…its technically irrelevant. You can only pay their NOI in debt service and that would mean you would not get any cash flow.
Now the calculation (seller financing calculator) is to decide how much of the properties NOI do you want to give to the seller and how much do you want to keep (cash flow) for your troubles.
For more information like this check out my articles on www.realestateraw.com.
