4150 N 12th St. Suite A, Phoenix AZ 85014 Phone: 1.800.254.9659 Fax: 602.254.3446
How to Section
Below is a list of ratios that will help you identify if the loan you are requesting is the best for your needs.

How to calculate the value of an income property (Estimation Purposes Only)
*PowerPoint Demonstration*

How to: Other (ratio and term explanations and equations)

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Common Underwriting Guidelines
Debt Service Coverage Ratio (DCR)

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For Multifamily
Capitalization Rate (Cap Rate)
The Capitalization Rate or Cap Rate is a ratio used to estimate the value of income
producing properties. Put simply, it is the net operating income divided by the sales
price or value of a property expressed as a percentage. Investors, lenders and
appraisers use capitalization rates to estimate the purchase price for different types
of income producing properties. A market cap rate is determined by evaluating the
financial data of similar properties which have recently sold in a specific market.
It provides a more reliable estimate of value than a market Gross Rent Multiplier
since the cap rate calculation utilizes more of a properties financial detail. The
GRM calculation only considers a properties selling price and gross rents. The
Cap Rate calculation incorporates a properties selling price, gross rents, non rental
income, vacancy amount and operating expenses thus providing a more reliable
estimate of value.

Cap rates may vary in different areas of a city for many reasons such as desirability
of location, level of crime and general condition of an area. Investors expect larger
returns when investing in high risk income properties. In a real estate market
where net operating incomes are increasing and cap rates are declining over time
for a given type of investment property such as office buildings, values will be
generally increasing. If cap rates are increasing over time and net operating
incomes are decreasing for residential income property in a particular market
place, residential income property values will be declining. If you would like to
find out what the cap rate is for a particular type of property in a given market
place, check with an appraiser or lender in that area. Be aware that the frequency
of sales for commercial income properties in a given market place may be low and
reliable cap rate data may not be available.

If you are able to obtain a market cap rate from an appraiser or lender for the type
of property you are evaluating, check to see if the cap rate value was determined
with recent sales of comparable properties or if it was constructed. When adequate
financial data is unavailable, appraisers may construct a cap rate through analysis
of it's component parts thus reducing the credibility of the results. Cap rates which
are determined by evaluating the recent actions of buyers and sellers in a particular
market place will produce the best market value estimate for a property.
If you are able to obtain a market cap rate, you can then use this information to
estimate what similar income properties should sell for. This will help you to gauge
whether or not the asking price for a particular piece of property is over or under

aaaaaaaaaaaNOIaaaaaaaaaaaaaaaaaaaaaaa NOI
Cap Rate = -------- Estimated Value = -------------
aaaaaaaaaaaValue aaaaaaaaaaaaaaaaaaaaCap Rate

Example 1: A property has a NOI of $155,000 and the asking price is $1,200,000.

Cap Rate = -------------- X 100 = 12.9 rounded

Example 2: A property has a NOI of $120,000 and Cap Rates in the area for this
type of property are 12%.

Estimated Market Value = ------------ = $1,000,000

Net operating income is determined by subtracting vacancy amount and
operating expenses from a properties gross income. Operating expenses
include the following items: advertising, insurance, maintenance, property
taxes, property management, repairs, supplies, utilities, etc. Operating
expenses do not include the following items; Improvements such as a new roof,
personal property such as a lawn mower, mortgage payments, income and
capital gains taxes, loan origination fees, etc.

Appraisers use the Income Approach, Cost Replacement and Market Comparison
methods to estimate the value of property. The Income Approach utilizes the
theory of Capitalization.
Cash on Cash Return
Cash on Cash Return measures the return on cash invested in an income producing
property and is expressed as a percentage. It is calculated by dividing before-tax cash
flow by the amount of cash invested. If before-tax cash flow for an investment property
is equal to $15,000 and our cash invested in the property is $100,000, cash on cash
return is equal to 15%.

aaaaaaaaaaaaaaaaaaaaaaaaBefore-Tax Cash Flow aaaaaaaaaaaaa$15,000
Cash on Cash Return = ------------------------------ X 100 = ------------- X 100 = 15%
aaaaaaaaaaaaaaaaaaaaaaaaaaCash Invested aaaaaaaaaaaaaaaaa$100,000

The following shows how before-tax cash flow is derived.

Gross Income aaaaaaaaaaaaaaaaaa54,500

Less Vacancy Amount aaaaaaaaaaa(2,500)
Gross Operating Income aaaaaaa52,000

Less Operating Expenses aaaaaaaa(17,000)

Net Operating Income aaaaaaaaaa(35,000)

Less Annual Debt Service aaaaaaa(20,000)
Before-Tax Cash Flow aaaaaaaaa15,000

Cash on Cash Return is used to evaluate the profitability of income producing
properties. It is one of many financial tools used by investors to compare different
income producing properties. Be aware that it only considers before-tax cash flows
and doesn't take into account an investors individual income tax situation. Also it
doesn't consider the wealth building potential of a property via appreciation. A
property in one area of a city may have a better Cash on Cash Return then a
property in another location, but it may not appreciate as fast because of it's location.
One location may be more desirable than the other.
Common Underwriting Guidelines

Commercial Financing is underwritten on a case by case basis. Every loan application is unique and evaluated on its own merits, but there are a few common criteria lenders look for in commercial loan packages.

Financial Analysis
A key component in making an underwriting evaluation is the debt coverage ratio. The DCR is defined as the monthly debt compared to the net monthly income of the investment property in question. Using a DCR of 1:1.10 a lender is saying that they are looking for a $1.10 in net income for each $1.00 mortgage payment. Typically they will determine the DCR ratio based on monthly figures, the monthly mortgage payment compared to the monthly net income. The higher the DCR ratio the more conservative the lender. Most lenders will never go below a 1:1 ratio ( a dollar of debt payment per dollar of income generated). Anything less then a 1:1 ratio will result in a negative cash flow situation raising the risk of the loan for the lender. DCR's are set by property type and what a lender perceives the risk to be. Today, apartment properties are considered to be the least risky category of investment lending. As such, lenders are more inclined to use smaller DCR's when evaluating a loan request. Make sure that you are familiar with a lender's DCR policy prior to spending money on an application. Ask them to give you a preliminary review of the investment property that you want to purchase. Information is free, mistakes are not.

Loan to Value
Unlike residential lending, commercial investment properties are viewed more conservatively. Most lenders will require a minimum of 20% of the purchase price to be paid by the buyer. The remaining 80% can be in the form of a mortgage provided by either bank or mortgage company. Some commercial mortgage lenders will require more than 20% contribution towards the purchase from the buyer. What a bank/lender will do is subject to their appetite and the quality of the buyer and the property. Loan to value is the percentage calculation of the loan amount divided by purchase price. If you know what a lender's LTV requirements are, you can also calculate the loan amount by multiplying the purchase price by the LTV percentage. Keep in mind that the purchase price must also be supported by an appraisal. In the event that the appraisal shows a value less then the purchase price, the lender will use the lower of the two numbers to determine the loan that will be made.

Credit Worthiness
For businesses less than three years old, personal credit of principals will be evaluated. This may hold true for longer periods of time for tightly held companies. For corporations, business performance and credit ratings will be evaluated with a proven track record.

Property Analysis
Fair Market Value and Fair Market Rent will be analyzed. Special use property may require additional underwriting. Age, appearance, local market, location, and accessibility are some other factors considered

Debt Service Coverage Ratio (DSCR)
Also known as Debt Service Coverage Ratio (DSCR). The debt coverage ratio is
a widely used benchmark which measures an income producing property's ability
to cover the monthly mortgage payments. The DCR is calculated by dividing the
net operating income (NOI) by a properties annual debt service. Annual debt service
equals the annual total of all interest and principal paid for all loans on a property.
A debt coverage ratio of less than 1 indicates that there is inadequate cash flow
generated by an income property to cover the mortgage payments. For example, a
DCR of .9 indicates a negative cash flow. There is only enough income available
to pay 90% of the annual mortgage payments or debt service. A property
with a DCR of 1.25 generates 1.25 times as much annual income as the annual
debt service on the property. In this example, the property creates 25% more
income than is required to cover the annual debt service.

Example: We are considering buying an investment property with a net operating
income of $24,000 and annual debt service of $20,000. The DCR for this property
would be equal to 1.2. This means that it generates 20% more annual income than
is required to cover the annual mortgage payment amount.

aaaaaaaaaaaaaaaaaaaaaaaNet Operating Income aaaaaaaa$24,000
Debt Coverage Ratio = ------------------------------ = ----------- = 1.2
aaaaaaaaaaaaaaaaaaaaaaaaAnnual Debt Service aaaaaaaa$20,000

Many lending institutions require a minimum debt coverage ratio value to procure
a loan for income producing properties. DCR requirements for lending institutions
may vary from as low as 1.1 to as high as 1.35. From a lending institutions
perspective, the higher the DCR value, the more income there is available to cover
the debt service and thus the less the risk.

Net Operating Income (NOI) is calculated as follows:


Gross Rents Possible ---------35,000

Other Income -----------------2,000
Total Gross Income --------37,000

Less Vacancy Amount --------(3,000)
Gross Operating Income ---34,000

Less Operating Expenses ----(10,000)
Net Operating Income -----24,000

Operating Expenses include the following items; advertising, insurance,
maintenance, property taxes, property management, repairs, supplies, etc.
Depreciation is the loss in value of an asset / building over time due to wear and
tear, physical deterioration and age. The cost of reproducing an income property
can be recovered over the useful life of the asset which is determined by law. Only
the building can be depreciated and not the land. Residential income property must
be depreciated over a 27.5 year period using straight line depreciation. Commercial
income property must be depreciated over 39 years using straight line depreciation.
Straight line depreciation stipulates that an asset must be depreciated by equal
amounts each year over its useful life.

Example: You purchase a warehouse for $900,000. The land where the warehouse
resides is valued at $120,000. The building is valued at $780,000. Current law
allows you to depreciate commercial properties by equal amounts annually over 39
years. Your depreciation deduction for the first year is based on the mid month
convention. The day of the month that you purchase the property doesn't matter.
You can only deduct half of the first months depreciation. If you put the warehouse
into service on June 1, you are allowed to deduct 6 and 1/2 months of depreciation
for the first year.

----------- = $20,000
First Year Depreciation = 6.5 X ( --------- ) = $10,833

Accountants calculate a full year of depreciation for the above warehouse
(commercial properties) by multiplying 2.56 % times 780,000 which equals 19968.
A full year of depreciation for residential income properties would be calculated
by multiplying 3.64 % times the building basis.

The depreciation deductions that you write-off in any year reduce you taxable
income thus increasing your profit for that year.

Capital improvements are subject to the same depreciation laws. Capital
improvements include the following; a new roof, a new furnace, an addition to a
building, siding, etc.

Example: You have owned the above warehouse for about 7 years now and it is in
need of a new roof. The cost of the new roof is $19,500. You are allowed to
depreciate thecost of the roof over 39 years. If you put the new roof on in July, you
are allowed to deduct 5 and 1/2 months of depreciation in the first year.

--------- = $500
First Year Depreciation (roof) = 5.5 X ( ----- ) = $229

Accountants would calculate a full year of depreciation for the roof by multiplying
2.56 % times $19,500 which equal 499.

All depreciation amounts that you write-off in each year for the building and
capital improvements reduce your adjusted basis for the property thus increasing
the taxable profit you must declare when you sell.

Discounted Cash Flow
Click on the link below to see the explanation for discounted cash flows

Discounted Cash Flows Calculator and Example

Gross Rent Multiplier
The Gross Rent Multiplier or GRM is a ratio that is used to estimate the value
of income producing properties. The GRM is calculated by dividing the sales price
by either the monthly potential gross income or by dividing the sales price by the
yearly potential gross income. When detailed financial information is available
for the recent sales of similar properties in a particular area, a market GRM can
be used to provide a rough estimate of value.

Example 1: If the sales price for a property is $200,000 and the monthly potential
gross rental income for a property is $2,500, the GRM is equal to 80. Monthly
potential gross income is equal to the full occupancy monthly rental amount which
assumes all available rental units are occupied. Generally speaking, properties in
prime locations have higher GRM's than properties in less desirable locations.
When comparing similar properties in the same area or location, the lower the GRM,
the more profitable the property from an income perspective. This statement
assumes that operating expenses are proportionate for the properties being
compared. Since the GRM calculation doesn't include operating expenses, this
statement might not hold true for similar properties where one of the properties
has significantly higher operating expenses.

aaaaaaaaaaaaaaaaaaaaaaaaaSales Priceaaaaaaaaaaaaaaaaaaaaa $200,000
GRM (monthly) = ------------------------------------------- = ------------ = 80
aaaaaaaaaaaaaaaaaaaaMonthly Potential Gross Income aaaaaaaaaa$2,500

Example 2: We have several similar properties that have sold recently and their
average monthly GRM is 80. We can use this information to estimate the value
of comparable properties for sale. If our monthly potential gross income for a
property is equal to $3,000, we would estimate its value in the following way.

Estimated Market Value = GRM X Potential Gross Income

= 80 X $3,000 = $240,000

The GRM can provide a rough property value estimate when consistent and
accurate financial information is available for recent sales of similar properties,
but be aware of it's limitations. Operating expenses, debt service and income tax
consequences are not included in the GRM calculation. We could have a situation
where two properties have approximately the same potential gross income, but
one property has significantly higher operating expenses. The above formula
would result in a questionable estimation of the market value for these
properties. Also, the above GRM formula uses the monthly potential gross
income and doesn't account for the vacancy factor which could have an impact
on the accuracy of the property value estimates. This is why it is important
to have recent and accurate financial information for comparable sales
when establishing a GRM or Cap Rate for income producing properties.

The GRM is sometimes calculated using the effective gross income rather
then the potential gross income thus incorporating the vacancy factor in the
GRM calculation. Effective Gross income is equal to a properties potential
gross income minus the vacancy amount. When vacancy rates are a factor,
using the effective gross income will produce a more reliable estimate.

The capitalization rate is a more reliable tool for estimating the value of
income producing properties since vacancy amount and operating
expenses are included in the cap rate calculation. The GRM is useful
in providing a rough estimate of value.

Income Approach

The income approach is rarely used to determine the value of a home that will be financed by an FHA insured loan unless it is an income producing property (such as a triplex or four-plex). The income approach is an analysis based on the relationship of value as related to the market rent that a property can be expected to earn.

Market rent is the rental income that a property would most likely receive on the open market as indicated by current rentals paid for comparable space. In addition, the appraiser will analyze the sales prices of comparable properties in order to determine the gross rent multiplier (GRM) that represents the relationship between market rent and market value. This ratio is calculated by:

Sales Price divided by Gross Rent = GRM

The following illustrates how to calculate a monthly gross rent multiplier:

aaaaaaComparable aaaaaaaSales Price aaaaaaaMonthly Rent aaaaaGross Rent Multiplier
aaaaaaaaaaaaaaa1 aaaaaaaa$90,000 aaaaaaaaaaaa$750 aaaaaaaaaaaaaaaa120.00
aaaaaaaaaaaaaaa2 aaaaaaaaa85,000 aaaaaaaaaaaaa690 aaaaaaaaaaaaaaaa123.19
aaaaaaaaaaaaaaa3aaaaaaaaa 87,000 aaaaaaaaaaaaa715 aaaaaaaaaaaaaaaa121.68
aaaaaaaaaaaaaaa4 aaaaaaaaa95,000 aaaaaaaaaaaaa800 aaaaaaaaaaaaaaaa118.75
aaaaaaaaaaaaaaa5 aaaaaaaaa89,000 aaaaaaaaaaaaa730 aaaaaaaaaaaaaaaa121.92

Average: 121.11

Based upon this analysis, the appraiser can used this estimated GRM and apply it to the projected gross rents of the subject property. For example, if the appraiser had determined that the market rent for the subject property is $700 per month, the estimated value of the subject property would be:

Gross Rent x GRM = Market Value

$700 x 121.11 = $84,777

IRR (Internal Rate of Return)
IRR (Internal Rate of Return) put simply is the average annual yield on an investment.
The After-Tax IRR calculation for each year uses the initial investment amount, the
series of After-Tax Cash Flows and the After-Tax Sales Proceeds in a particular year to
establish an average return on investment. For example, if we were calculating an IRR
5 years in the future for an investment we would use the Initial Investment amount, the
After-Tax Cash Flows for each of the five years and the After-Tax Sales Proceeds in
year five, the final year, to calculate an average After-Tax IRR for the investment. The
real estate model calculates an After-Tax IRR in years 1 through 10 using this method.
Be aware of one thing when looking at the IRR calculations. If in year 5 you have a
return of 15 %, this means that your After-Tax Cash Flows in each year are ran forward
at 15%. When calculating the MIRR for Future Wealth, On Target allows you to
determine what rate of return you would like to run your cash flows at. The MIRR for
Future Wealth therefore provides a more accurate return on investment in each year.

Leverage is the use of borrowed money to increase your profits in an investment.
Building wealth via real estate requires the use of leverage. Let's assume you have
$100,000 to invest and you purchase a small income property for $100,000. Income
properties have been appreciating at an average of 7% per year. At the end of the
first year of operation, your property is worth $107,000. At the end of year two, it
is worth $114,490. Now let's assume that you put your $100,000 down on a $500,000
income property. At the end of the first year, it is worth $535,000. At the end of
the second year, it is worth $572,450. By borrowing money to purchase a larger
income property, you have increased your profit by $57,960 in just two years.
To get the full advantage of leverage, put the minimum down on a good property
which has a strong likelihood of appreciating in value. Stay away from questionable
properties in run down areas.

When you purchase a piece of real estate, you make use of leverage when you
borrow money towards the purchase price. The principal of leverage can be
demonstrated very easily with an investment model. For those of you who own
"ON TARGET", bring up Sample 1. Run the model with the current data and go
to the reports section. Take a good look at the MIRR (Modified Internal Rate of
Return) values on the Future Wealth report or print a copy of the report. Go back
to the input section by clicking on input. Change Loan 1 Amount on the Property
Data screen from $300,000 to $350,000. This will reduce your down payment from
$92,073 to $42,323. Click on run and go back into the Future Wealth report.
Your Before-Tax and After-Tax MIRR values have increased substantially for
all years. The model clearly demonstrates the principal of leverage.
LTV (Loan to Value) Ratio
The loan-to-value or LTV is a ratio between the loan balance and the market value
of a property expressed as a percentage. For example, a property with a loan
balance of $400,000 and a market value of $500,000 has a LTV of 80%.

Balance of Loans aaaaaaaaaaaaaa$400,000
LTV = ----------------------- X 100 aaa= ------------ X 100 = 80%
aaaaaaaaaMarket Value aaaaaaaaaaaaaaaa$500,000

The LTV can be used to estimate the amount of equity you have in a property.
If the LTV for a property is 75%, your equity position in a property is 100 minus
75 or 25%. You can then multiply .25 times the market value to determine the
equity amount.

Lenders may require mortgage insurance on loans with LTV's that are greater
than a predetermined amount, usually 80%. This means that the purchaser of
a property will need to put a minimum of 20% down to avoid paying mortgage
insurance premiums. Mortgage insurance is a premium amount which is added
to the monthly mortgage payment.

The LTV is also used when an investor wishes to refinance a property. For
example, you have owned an investment property for a number of years and
you would like to refinance the property to take cash out. Most lenders will
allow a maximum of 75% the appraised value for the new loan amount.
Lenders who refinance at LTV's greater than 75% will usually charge less
favorable interest rates.
MIRR for Future Wealth
The Modified Internal Rate of Return on Future Wealth is the best indicator to
evaluate the overall return on an income property investment. Cumulative cash
flows and gains resulting from the sale of the property are accumulated on a
year-to-year basis to arrive at a Future Wealth amount. You determine the rate of
return you would like to run your cash flows forward at. The IRR calculation
determines this value for you and may therefore exaggerate your return on cash flows.
Also overestimating the appreciation growth rate can distort Future Wealth. Once
you've narrowed down your property selections, you may want to run low, medium
and high appreciation growth rate scenarios through the model. This will give you a
range of Future Wealth possibilities.

Rate of Return Example


As CFO of a small manufacturing company, it is important that you monitor carefully the new project opportunities presented to the firm. Your hurdle rate is now 22%.
A new 5-year venture has been proposed which is projected to return the following contributions (end of year) to Earnings and Overhead:

Year 1 $104,000

Year 2 $157,500

Year 3 $207,000

Year 4 $243,000

Year 5 $298,500

The initial cost of the project is $325,000, but an additional cost in the amount of $180,000 is expected to be incurred at the end of year 2.

If your safe rate of investment is 5%, will this project meet your new investment criteria? What will be the raw (unadjusted) Internal Rate of Return?

What will be the Modified Internal Rate of Return if you can use the cashflows from previous years to fund deficits?

Here's the Answer


The combination of a positive cashflow of $157,500 in year 2, together with an additional investment at the end of year 2 of -$180,000 results in a net cashflow at the end of year 2 of -$22,500.

Using this net cashlfow series, the raw Internal Rate of Return is found to be 30.15%.

In calculating the raw IRR, the negative cashflow of -$22,500 is theoretically discounted back at the IRR to Present Value, which implies that this relatively small amount can be invested at the IRR (30.15%) to yield $22,500 in 2 years. Few such investments exist which provide the certainty required to cover the future negative cashflow at this rate of return.
Therefore, we must adjust this cashflow to provide for the future negative flow by investing sufficient sums today at the safe rate.

Calculating the MIRR:

In order to offset the second year's negative cash flow, invest only sufficient funds from the first year at the safe rate for 1 period so that $22,500 will be available at the end of year 2.

aaaaaaaaaaaaaaaaaaaaaaanaa i aaaPVaaa PMTaaaaaa FV
aaaaaaaaaaaaaaaaaaaaaa1 aa5 aa? aaa.a0aaaa 22,500

We find that $21,428.57, invested for one year @ 5% will yield the $22,500 needed to cover the negative cashflow at the end of the second period.

This reinvestment will neutralize the negative cashflow in year 2. But this amount taken from the cashflow in Year 1 will leave a remaining cash flow of $82,571.43 ($104,000 - 21,428.57) in the first period. The net cashflow in the second period will now be zero.

Now recalculate the IRR (now the MIRR) using the adjusted cashflow series.

1. 82,571.43
2. 0aaaaaaa
3. 207,000a
4. 243,000a
5. 298,000a

The Modified Internal Rate of Return is 29.77%

This method of offsetting negative cashflows is much to be preferred over the method which appears in the HP-12C handbook, and which is copied by Excel:

"discount all negative cashflows back to present value, and compound all
positive cashflows forward at the reinvestment rate to Future Value."

At what re-investment rate should the positive cashflows be compounded forward?
And how would we determine that rate?

The requirement for additional up-front cash, as the result of discounting all negative cashflows to Present Value, has a pronounced negative effect on the IRR, lowering yield returns significantly.
The re-investment rate is never given, but the suggested re-investment rate is mentioned as the the investor's opportunity cost of funds.

The method of determining the MIRR, which requires the discounting of all negative cashflows back to a Present Value, and the compounding forward of all positive cashflow to Future Value at an unspecified re-investment rate, is the source of the often-repeated fallacy that "the IRR depends upon the reinvestment rate of the cashflows flowing from the investment."
Nothing is farther from the truth.

The method described here will always result in a higher MIRR, and will always obviate the need to choose a "re-investment rate."

Net Income Multiplier
The Net Income Multiplier or NIM is a factor that is used to estimate the market
value of income producing properties. It is equal to the market value of a property
divided by the net operating income or NOI.

Example 1: A residential income property has an NOI of $15,000 and a market value
of $150,000.

aaaaaaaaaaaMarket Value aaaaaaaaaaaa$150,000
NIM = ----------------------------- = ------------ = 10
aaaaaaaaNet Operating Income aaaaaaaa$15,000

Example 2: The average net income multiplier for recent sales of comparable
properties in a particular area is 9 and the net operating income for a similar
property we are considering buying is $20,000.

Market Value = NIM X NOI = 9 X $20,000 = $180,000

The net income multiplier and the cap rate are financial tools used to estimate
the market value of income properties. The cap rate is better known and more
widely used by most investors. The cap rate and the NIM produce identical
results when estimating the market value of an income property since the net income
multiplier is the inverse of the cap rate. The cap rate is equal to 100 divided by
the NIM. The NIM is equal to 100 divided by the cap rate.

aaaaaaaaaaa100 aaaaaaaaaaaaaaaaaaaaaaaaa100
Cap Rate = ------- aaaaaaaaaaaaaaaNIM = ------------
aaaaaaaaaaaNIM aaaaaaaaaaaaaaaaaaaaaaaaCap Rate

When using the capitalization rate and the net income multiplier to estimate the
value of an income property, accurate and current financial data for comparable
sales of similar properties is required.