|
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. | |
| | |
 | | |  |
 | | |  |
 | | | | | | |
| | Market
Data |
 | | |
| | | | | |
| | |
| | -
PRIME RATE |
| | | |
-
U.S. TREASURIES |
 | | |
| | | | | |
| | |
| | | |
|
| | | |
|
| | | | | | | |
| CLICK
PICTURE | | | | | | |
| | | | |
| |
| For
Multifamily | | | | |
|
Presentation | | | | |
| | | | | |
| | | | | | | |
| | | | | | | | | | |
| | | | | | | |
|
| 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
priced.
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.
aaaaaaaaaaaa$155,000
Cap Rate = --------------
X 100 = 12.9 rounded
aaaaaaaaaaa$1,200,000
Example 2: A property has a NOI of $120,000 and Cap Rates in the area for
this
type of property are 12%.
aaaaaaaaaaaaaaaaaaaaaaa$120,000
Estimated Market Value = ------------ = $1,000,000
aaaaaaaaaaaaaaaaaaaaaaaaaa.12
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:
Income
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 |
|
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.
aa780,000
----------- = $20,000
aaaa39
aaaaaaaaaaaaaaaaaaaaaaaaaaaaa20,000
First Year Depreciation = 6.5 X
( --------- ) = $10,833
aaaaaaaaaaaaaaaaaaaaaaaaaaaaaaa12
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.
a19,500
---------
= $500
aaa39
aaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaa500
First Year Depreciation (roof) = 5.5 X ( ----- ) = $229
aaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaa12
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.
| | |
| | |
| | | | | | | | |
| | | |
| | | | | | | | |
|
| 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
aaaaaaaaaaaaaaaaaaaa= 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 |
|
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%.
aaaaaaaaBalance 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
Question
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 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
aaaaaaaaaaaaaaaaaaaaaaaaaaaaaa-21,428.57 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. 0(325,000)
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. | |
| | | | |
| | | | | | | | | |
| | | | | | | | | | |
|
| Net
Operating Income (NOI) | |
Net
Operating Income is equal to a properties yearly gross income less operating
expenses. Gross income includes both rental income and other income such as
parking fees, laundry and vending receipts, etc. All income associated with a
property. Operating expenses are costs incurred with the operation and
maintenance of a property. They include repairs and maintenance, insurance,
management fees, utilities, supplies, property taxes, etc. The following are not
operating expenses: principal and interest, capital expenditures, depreciation,
income taxes, and amortization of loan points. Net operating income is calculated
like this. Income
Gross Rents Possibleaaaaaaaaaa 100,000
Other Incomeaaaaaaaaaaaaaaaaa+ 3,000
Potential
Gross Income aaaaaaaaaaaaa103,000
Less vacancy
Amountaaaaaaaaaa(2,000)
Effective Gross Income
aaaaaaaaaaaaa101,000
Less Operating Expenses
aaaaaa(31,000)
Net Operating Incomeaaaaaaaaaaaaaaa
70,000 Net
operating income or NOI is used in two very important real estate ratios. It is
an essential ingredient in the Capitalization Rate (Cap Rate) calculation
that is used
to estimate the value of income producing properties. Lets assume
we have a market
capitalization rate of 10 for the type of property we are
considering purchasing. A
market cap rate is calculated by evaluating the
financial data from current sales
of similar income producing properties
in a given market place. We are evaluating
a similar income property that
is currently for sale with a net operating income of
$50,000. We would estimate
the value of this property like this. aaaaaaaaaaaaaaaaaaaaaaNet
Operating Incomeaaaaaaaaaa 50,000
Estimated
Value =aa ------------------------------- = --------------
= 500,000
aaaaaaaaaaaaaaaaaaaaaaaCapitalization
Rateaaaaaaaaaaaaa .10 Another
important ratio that is used to evaluate income producing properties is
the
Debt Coverage Ratio or DCR. The NOI is a key ingredient in this important ratio
also. Lenders and investors use the debt coverage ratio to measure a property's
x ability to pay it's operating expenses and mortgage payments. A debt coverage
ratio of 1 is breakeven. Most lenders require a minimum of 1.1 to 1.3 to
be
considered for a commercial loan. From a bank's perspective and an investor's
perspective, the larger the debt coverage ratio, the better. Debt coverage
ratio is
calculated like this. aaaaaaaaaaaaaaaaaaaaaaaaaaNet
Operating Incomeaaaaaaaaa 50,000
Debt Coverage
Ratio =aaaa ------------------------------ = ----------
= 1.25
aaaaaaaaaaaaaaaaaaaaaaaaaaDebt Service
aaaaaaaaaaaaaaaaa40,000 Debt
service is the total of all interest and principal paid in a given year. It is
equal to the mortgage payment times 12 or the mortgage payments times 12
if
you have multiple loans on a property.
| |
| | | | |
| | | | | | | | |
| | | | | | | | | | |
|
| Operating
Expenses | |
Operating
Expenses are costs associated with the operation and
maintenance of an income
producing property. They include the
following items. Accounting
Expensesaaaa a License Feesaaaaaaaaa
aaaaaaaSnow Removal
Advertising aaaaaaaaaaa.aaOffice
Expensesaaaaaa aaaaaaaaSupplies
Attorney Fees
aaaaaaaaaaaPest ControlaaaaaaaaaaaaaaaaaTelephone
Insuranceaaaaaaaaaaaaaaa Property Managementaaaaaaaa
Trash Removal
Janitorial Service aaaaaaaaaProperty
Taxes aaaaaaaaaaaaaaTravel Expenses
Lawn Care
aaaaaaaaaaaaa.aRepair Costs aaaaaaaaaaaaaaaaVehicle
Expense
Leasing Commissionsaaaaa.aResident Manageraaaaaaaaaaaa
Utilities
Legal Feesaaaaaaaaaaaaa.aSalary and
Wages aaaaaaaaaaaaEtc. Operating
Expenses do not include the following. Capital
Expenditures
- Improvements such as a new roof, new windows, the paving of
a driveway,
a building addition, etc.
- Personal property such as lawn
mowers, snow removal equipment, etc.
Income and Capital Gains Taxes
Loan Origination Fees
Mortgage Payments | |
| | | | |
| | | | | | | |
|
| Personel
Debt Ratio (PDR) | |
| When
analyzing the personal budget of a borrower, lenders use two different debt ratios
to determine if the borrower can afford his obligations. These
two debt ratios are:
Top Debt Ratio
Bottom Debt Ratio
The "top" debt ratio is defined as:
Top Debt Ratio = Monthly
Housing Expense/Gross Monthly Income
By "monthly housing expense"
we mean either the borrower's monthly rent payments, or if she owns her own home,
the total of the following -
-Monthly Housing Expense
-1st mortgage
payment on home plus
-Real estate taxes (annual cost/12) plus
-Fire
insurance (annual cost/12) plus
-Homeowner's association dues(if home is
a condo or townhouse) plus
-Second mortgage payment (if any) plus
-Third
mortgage payment (if any). You
will often hear the term P.I.T.I. It refers to (P)rincipal, (I)nterest, (T)axes
and (I)nsurance. While P.I.T.I. is not exactly the same as Monthly Housing Expense
because it does not include homeowner's association dues, the two terms are often
used interchangably.
Lenders have learned over the years that a borrower's
"top" debt ratio should not exceed 25%. In other words, a person's housing
expense should not exceed 1/4 of his income. While lenders will often stretch
this number to as high as 28%, traditional lending theory maintains that anyone
with a debt ratio in excess of 25% stands a good chance of developing budget problems.
Operating Expenses do not include the following.
The
second ratio that lenders use to determine if a borrower can afford her obligations
is the "bottom" debt ratio. It is defined as follows:
Bottom
Debt Ratio = (Total Housing Expense + Debt Payments)/Gross Monthly IncomeOperating
Expenses do not include the following. The
only difference between the two ratios is the inclusion in the numerator of "debt
payments." Debt payments include the following:
-Debt Payments
-Car payments
-Charge card payments
-Payments on installment loans,
for example - a payment on a washer & dryer that the borrower purchased.
Payments on personal loans, for example - a signature loan from the borrower's
bank.
What is not included in "debt payments" is Utilities such
as PG&E, water or telephone and payments on real estate loans. Real estate
loans are usually offset first by the net rental income from the property. If
the borrower has a net positive cash flow from all his rentals, then the net income
is usually added to his "gross monthly income." If the borrower has
a net negative cash flow from all of his rental properties, then the amount of
the negative cash flow is usually added to the numerator of the "bottom"
debt ratio as if it were a monthly debt obligation, like a car payment.
Traditional
lending theory maintains that a borrower's "bottom" debt ratio should
not exceed 33 1/3%. In other words, the total of the borrower's housing expense
and debt obligations should not exceed 1/3 of his income. Lenders often will stretch
on this ratio to as high as 36%, and some have even been known to stretch as high
as 40% or more. Obviously a loan with a debt ratio of 40% is a far more risky
loan than a loan with a debt ratio of 32%. | |
| | | | |
| | | | | | | | | | |
| | | |
| Mortgage
Banker Number:14116 | | |
| | | | | | | | | | |
