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Total Original Investment
Down payment, plus closing costs, plus loan points, plus other costs, equals total initial investment.
Gross Scheduled Income
Gross Scheduled Income (GSI) is the maximum amount of annual rent you would receive if the property were 100 percent occupied all year.
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Ask yourself or the owner the following questions in order to arrive at reasonable assumptions:
Gross Scheduled Income
· What are the current rents, according to the lease and rental agreements?
· Are these market rents?
· How long do these agreements run?
· Are the tenants prompt payers?
· When were rents last increased?
· What did the owner report as rental income on his Schedule E?
· If there is a property manager, what do his records show as collected rents?
Effective Rental Income
Effective rental income is obtained by subtracting Vacancies & Uncollected Rents from Gross Scheduled Income. It represents the actual amount of money collected in rents for the year.
Gross Scheduled Income
- Vacancy/Credit Losses
= Effective Rental Income
Gross Operating Income
Gross Scheduled Income
- Vacancy/Credit Losses
= Effective Rental Income
Effective Rental Income
+ Other Income
= Gross Operating Income
Operating Expenses
Annual Operating Expenses are the actual costs involved in running the property.An annual expense budget should include sufficient funds to ensure that the property continues to produce market rents. If maintenance is deferred for a prolonged period, the property's ability to compete for the best renters will be diminished. Operating expenses include:
· Property tax
· Insurance
· Property management
· Maintenance and repair
· Utilities
· Services (garbage, janitorial, pool, elevator, lawn, etc.)
· Other Expenses
**Loan payments are not considered an annual operating expense. ** Loan payments are a financial cost to an owner who chooses to borrow rather than pay cash. Also, operating expenses do not include cash outlays for major improvements. These outlays, called capital additions, must be placed on a cost-recovery or depreciation schedule and deducted over time.
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A typical expense statement for a small residential rental contains the following breakdown:
Annual Operating Expenses
1. Accounting and Legal
2. Advertising, Licenses and Permits
3. Property Taxes
4. Property Insurance
5. Property Management
6. Repairs and Maintenance
7. Utilities
a. electricity
b. gas and oil
c. sewer and water
8. Services
a. garbage
b. gardening, pest, pool, and ground maintenance
9. Miscellaneous expenses
Net Operating Income
Gross Scheduled Income
- Vacancy/Credit Losses
= Effective Rental Income
+ Other Income
= Gross Operating Income
- Annual Expenses
= Net Operating Income
Net Operating Income is considered by many to be the single most important number in investment analysis. This is the number used by appraisers to determine value. It is used by lenders to determine the amount they will lend. It is the amount of money available to pay the mortgage and ultimately determines whether you'll have a positive or negative cash flow.
Annual Debt Service
Annual Debt Service(ADS) is the total of all monthly loan payments (principal and interest) paid throughout the year on all mortgages.
Example:
An investment property with a 30-year fixed-rate first mortgage with monthly payments of $1,118.74 and no second mortgage.
Monthly payment of $1,118.74 X 12 months =$13,424.92
Principal and Interest Mortgage 1 $13,424.92
+ Principal and Interest Mortgage 2 0
= Annual Debt Service $13,424.92
Capital Additions
Expenses for major improvements (Capital Additions) like new roofs, fence installation/replacement, new carpet etc. cannot be completely deducted in the year they are completed. They are added your basis in the property and placed on a new cost recovery schedule (depreciation schedule).
Note: Consult your accountant or tax professional on all tax matters.
Annual Cash Flow Before Tax
In the cash flow model, annual debt service and capital additions are deducted from NOI to arrive at before-tax cash flow.
Gross Scheduled Income
- Vacancy
= Effective Rental Income
+ Other Income
= Gross Operating Income
- Annual Expenses
= Net Operating Income
- Annual Debt Service
- Capital Additions
= Before-Tax Cash Flow
If replacement reserves are used to fund capital additions in your analysis, replacement reserves take the place of capital additions in the cash flow model.
Gross Scheduled Income
- Vacancy
= Effective Rental Income
+ Other Income
= Gross Operating Income
- Annual Expenses
= Net Operating Income
- Annual Debt Service
- Annual Replacement Reserves
- Replacement Reserve Shortfall
= Before-Tax Cash Flow
Cap Rate
(Capitalization Rate)
Quick Reference:
Net Operating Income (NOI) = Cap Rate
Purchase Price
Net Operating Income (NOI) = Investment Value (Price)
Cap Rate
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Many Appraisers and investors us a cap rate along with the first-year Net Operating Income of an investment property to establish its value (price). A cap rate is the ratio (expressed as a percentage) between the purchase price and the first-year net operating income (NOI) of the property. An investor uses a cap rate to determine investment value while an appraiser uses a cap rate to determine market value. In either case, the value of the investment property is determined by dividing the first-year NOI by a cap rate.
Cap rates are market specific and can vary from neighborhood to neighborhood or even street to street. They are affected by the principles of supply and demand and can vary significantly according to perceived risk. In addition, investors may have different cap rate requirements. If you are trying to determine the appropriate cap rate for a specific market place, contact a real estate appraiser or real estate professional who is familiar with the market place.
Using a Cap Rate to Determine Investment Value
The following cap rate formula can be used to solve for the investment value (how much a buyer will pay) of a property, when the cap rate and the net operating income are known.
NOI = Investment Value (Price)
Cap Rate
Example:
Suppose a potential buyer is looking at a property listed for $200,000 with an estimated first-year NOI of $17,996. After looking at the cap rates of similar properties, the buyer has decided on a cap rate requirement of 9.25%. We can use the investors cap rate and the properties first year NOI to determine the properties Investment Value (the price the investor would be willing to pay).
NOI = Investment Value $17,996 (NOI) = $ 194,551
Cap Rate 9.25% Cap Rate
Determining the Cap Rate of an Investment
We can us a variation of the cap rate formula to solve for the cap rate of an investment property, when the net operating income is known and the price is fixed.
NOI = Cap Rate
Purchase Price
Example: In our previous example, the investor was looking at an investment listed for $200,000 with an estimated first-year NOI of 17,966. If this property were to be purchased at the list price, the cap rate for this investment would be 9%.
$17,966 = .09 or 9%
$200,000
Note: Once the Net Operating Income for an investment property has been determined we can make the following assumptions:
· The lower the cap rate, the higher the sales price.
· The higher the cap rate, the lower the sales price.
· Sellers want buyers to accept the lowest possible cap rate.
· From the buyers point of view, the higher the cap rate, the more attractive the investment becomes.
Pros and Cons in Using a Capitalization Rate (Cap Rate):
Pros: The main advantage of using a cap rate is its simplicity. It also accounts for vacancy and operating expenses.
Cons: The reliability of using a cap rate is limited because it only looks at a one-year forecast and does not take into consideration any financing or tax implications.
IRV Formula
(The IRV formula is just another way of looking at the same information listed above.)
Investors use the direct capitalization (IRV) formula to measure investment performance:
I = R Where: I = First-year NOI
V V =
Investment value (price) R = Cap rate
Example: An investment property selling for $200,000 with an estimated first-year NOI of $20,000 would have a capitalization rate of 10%.
$20,000 = .10 or 10%
$200,000
Using a Cap Rate to Determine the Value of an Investment
Investors use a variation of the direct capitalization (IRV) formula to solve for value:
I = V Where the cap rate (R) is determined by the
R prevailing market values and/or the buyer's requirements.
Practice Problem:
Suppose a potential buyer is looking at a property listed for $200,000 with an estimated first-year NOI of $18,400. After looking at the cap rates of similar properties, the buyer has decided on a cap rate requirement of 9.5%. Using the formula below, determine the purchase price he would be willing to pay.
V = I (Solve for V)
R
Answer:
Income (NOI) = Investment Value
Cap Rate
$18,400 (NOI) = $ 193,684
9.5% cap rate
Gross Rent Multiplier (GRM)
Quick Reference:
GSI x GRM = Investment value of property (Price)
Price divided by GSI = GRM
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The value of an investment property can be calculated using the estimated Gross Scheduled Income (GSI) for year one, multiplied by a factor known as the Gross Rent Multiplier (GRM). (Gross Rent, Gross Scheduled Rent, and Gross Scheduled Income are interchangeable terms.)
Reminder: Gross Scheduled Income (GSI) is the maximum amount of annual rent you would receive if the property were 100 percent occupied all year.
Since we only need the information from line one of the cash flow model, the GRM method of determining investment value is quick and easy.
Using the Gross Rent Multiplier to Determine the Value of an Investment Property
The gross rent multiplier used in evaluating investment property is typically derived from comparable properties in the marketplace and may be adjusted by the investor to reflect his or her specific requirements.
First-year GSI x GRM = Value of investment property
Example:
Suppose a potential buyer's gross rent multiplier (GRM) requirement is 6.75. (This means the investor will pay no more than 6.75 times the gross scheduled rent to purchase an investment property.) The property the buyer is considering has an estimated first-year gross scheduled income of $28,560. The investment value, or the amount this investor would be willing to pay for this property, is:
$28,560 x 6.75 = $192,780
Determining the Gross Rent Multiplier of an Investment
If you want to calculate the Gross Rent Multiplier for a potential investment, divide the asking price by the first year Gross Scheduled Income.
Example:
An investment property listed for $200,000 with a Gross Scheduled Income of $28,560 would have a Gross Rent Multiplier of 7.
$200,000 = 7.00
$28,560
Note: Once the Gross Scheduled Income for an investment property has been determined we can make the following assumptions:
· The higher the asking price, the higher the GRM.
· Sellers generally try to list and sell their properties at the highest possible GRM.
· Buyers typically try to purchase investment properties at the lowest possible GRM. The lower the GRM, the more attractive the investment becomes.
Pros and Cons in Using a Gross Rent Multiplier:
Pros: The gross rent multiplier is a convenient tool because of its simplicity.
Cons: The usefulness of the gross rent multiplier is limited by the fact that it does not take into account vacancy and uncollected rent, operating expenses, debt service, tax impact, or income past the first year.
Cash on Cash
Quick Reference:
Before-tax cash flow = % Return
Initial investment
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This measurement of investment performance is called Cash on Cash (C/C). This involves comparing an investor's initial investment to the potential before-tax cash flow an investment property is likely to produce. Let's assume the investor's initial investment is $45,000 ($40,000 down plus $3,400 in closing costs plus $1,600 for points). We will also assume the property produces a before-tax positive cash flow of $4,972 per year.
Before-tax cash flow = % Return
Initial investment
$4,972 (cash) = .11 or 11%
$45,000 (on cash)
Pros and Cons in Using Cash on Cash:
Pros: Cash on cash takes into consideration vacancy and uncollected rent, operating expenses, and debt service.
Cons: Cash on Cash does not take into consideration anything past a first-year forecast. It does not take into account tax considerations or any increase or decrease in equity.
Debt Coverage Ratio (DCR)
Quick Reference:
Net Operating Income = Debt Coverage Ratio
Annual Debt Service
or
NOI = DCR
ADS
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When lenders provide financing for commercial properties or apartment complexes with five units or more, they generally use a debt coverage ratio as a lending guideline.
Formula: Debt Coverage Ratio (DCR) is determined by dividing net operating income (NOI) by the annual debt service (ADS). Remember, annual debt service is the total principal and interest for all mortgages.
Net Operating Income = Debt Coverage Ratio or NOI = DCR
Annual Debt Service ADS
Example:
Observe the following Before-Tax Cash Flow model and the Debt Coverage Ratio derived lines 7 and 8.
1. GROSS SCHEDULED INCOME $ 28,560.00
2. – Vacancy & Uncollected Rents – $_ 1,428.00
3. = EFFECTIVE RENTAL INCOME = $ 27,132.00
4. + Other Income + $_ 418.00
5. = GROSS OPERATING INCOME = $ 27,550.00
6. – Annual Operating Expenses – $ 9,554.00
7. = NET OPERATING INCOME = $ 17,996.00
8. – Annual Debt Service – $ 13,755.12
9. = BEFORE TAX CASH FLOW = $ 4,240.88
$17,996.00 (NOI) = 1.31 DCR
$13,755.12 (ADS)
Understanding Debt Coverage Ratios
To understand DCR, let's look at a break-even property. A property with a NOI of $5,000 and an annual debt service of $5,000 would break even and have a DCR of 1.0 (one point zero).
$5,000 NOI = 1.0 DCR
$5,000 ADS
The before-tax cash flow for this investment property would be zero and would not generally be acceptable to a lender. Because income and expenses vary from month to month, lenders reduce their risk by making loans where the ADS is less than the NOI
Lenders typically like to see debt coverage ratios between 1.1 and 1.3 for low risk properties.
Solve for ADS: Let's assume that an investment property has a NOI of $5,000 and the lenders minimum DCR requirement is 1.2. We can divide the NOI by the DCR to solve for the maximum ADS the lender will accept.
NOI = ADS $5,000 = $4,167
DCR 1.2
Bottom Line: Lenders want to make sure that the income produced by the property is more than enough to pay the mortgage (annual debt service). A higher DCR means there is less risk in making the loan. An aggressive lender may only require a DCR of 1.1 while other lenders have DCR requirements as high as 1.25 or more.
DCR Using Reserves
Normal DCR: The formula for calculating a normal Debt Coverage Ratio (DCR) is as follows:
Net Operating Income = Debt Coverage Ratio or NOI = DCR
Annual Debt Service ADS
Modified DCR: Lenders often want to include replacement reserves when calculating a DCR.
NOI - Replacement Reserves = Modified DCR
Annual Debt Service
or
NOI - Replacement Reserves = Modified DCR
ADS
More Info:
When lenders provide financing for commercial properties or apartment complexes with five units or more, they generally use a debt coverage ratio as a lending guideline.
Example:
Observe the following Before-Tax Cash Flow model and the Debt Coverage Ratio derived lines 7 and 8.
1. GROSS SCHEDULED INCOME $ 28,560.00
2. – Vacancy & Uncollected Rents – $_ 1,428.00
3. = EFFECTIVE RENTAL INCOME = $ 27,132.00
4. + Other Income + $_ 418.00
5. = GROSS OPERATING INCOME = $ 27,550.00
6. – Annual Operating Expenses – $ 9,554.00
7. = NET OPERATING INCOME = $ 17,996.00
8. – Annual Debt Service – $ 13,755.12
9. = BEFORE TAX CASH FLOW = $ 4,240.88
$17,996.00 (NOI) = 1.31 DCR
$13,755.12 (ADS)
Understanding Debt Coverage Ratios
To understand DCR, let's look at a break-even property. A property with a NOI of $5,000 and an annual debt service of $5,000 would break even and have a DCR of 1.0 (one point zero).
$5,000 NOI = 1.0 DCR
$5,000 ADS
The before-tax cash flow for this investment property would be zero and would not generally be acceptable to a lender. Because income and expenses vary from month to month, lenders reduce their risk by making loans where the ADS is less than the NOI
Lenders typically like to see debt coverage ratios between 1.1 and 1.3 for low risk properties.
Solve for ADS: Let's assume that an investment property has a NOI of $5,000 and the lenders minimum DCR requirement is 1.2. We can divide the NOI by the DCR to solve for the maximum ADS the lender will accept.
NOI = ADS $5,000 = $4,167
DCR 1.2
Bottom Line: Lenders want to make sure that the income produced by the property is more than enough to pay the mortgage (annual debt service). A higher DCR means there is less risk in making the loan. An aggressive lender may only require a DCR of 1.1 while other lenders have DCR requirements as high as 1.25 or more.
Before-Tax IRR
(Internal Rate of Return "Before-Tax")
The internal rate of return (IRR) for an investment is the percentage rate earned on each dollar invested for each period it is invested. IRR is another term for interest. The internal rate of return gives an investor the means to compare alternative investments based on their yield.
IRR isolates the "return on" portion of the total amount of money received from the investment over the holding period. In order to have a "return on" investment, dollars received must exceed dollars put into the investment. This "return on" rate is dependent upon both the amount of the excess and when the excesses is received.
When purchasing an investment property you have an opportunity to receive monthly cash flow for the entire time you own the property. These monthly cash flows are considered a "return on" the investment.
If the property has appreciated in value sufficiently enough to overcome the cost of sale, the property owner receives at the close of escrow the net proceeds of the sale. The net proceeds is partly a "return of" the investment (the down payment). The balance of the net proceeds is an additional "return on" the investment.
IRR calculations allow you to estimate the value today of a future stream of cash flow (including the net proceeds from sale) against your initial investment. |