Chapter 10

Interest-Only Loans

Allow the borrower to pay the interest alone, on a monthly basis. The entire original principal is due at maturity

Debt Service Coverage Ratio (DCR)

Before financing a property, the lender must be satisfied that it is a good investment. One consideration is the return received by the lender over the term of the loan, which depends on such factors as the interest rate charged, points and so forth. The lender will evaluate the riskiness of the loan and often the individual borrower. This is the degree to which the NOI from the property is expected to exceed the mortgage payments. The lender would like a sufficient cushion so that if the NOI is less than anticipated the borrower will still be able to make the payments without using personal funds. Net Operating Income (NOI) /Annual Debt Service =DCR Lender typically require a minimum of 1.2-1.4

Capitalization Rate (Cap Rate)

CAP= Net Operating Income/Price It can be a useful measure of value if it is derived from the information about what investors have been paying for comparable properties

Financial Leverage

Considers the length of the holding period, the time value of money (a dollar is worth more today than tomorrow) and the decrease of the debt due to principal reduction. Basically, it examines the yield v. rate on investment. If the Return (IRR) on the total investment in a property is greater than the rate of interest on debt, the property is said to have positive financial leverage. i.e. if your analysis over a 10 year period produced an unleveraged IRR of 11% and a leveraged IRR of 18% it would be said that the property has positive financial leverage.

Gross Potential Income (GPI)

The Sum of the Gross Potential Rent (GPR) and the other income (ancillary income) +GPR +Other Income _______________________ =GPI

In order to do a proposal you will request (4)

-A current rent roll -2-3 years of trailing income and expenses -Mortgage Note -Other items depending on product type

The Importance of using Rent Comparable(s)

-Are Rents over-market? How does that affect the durability of the income stream? If it is a shorter term lease a buyer may underwrite with market rent v. actual rent -Are rents under-market? At market? How quickly can a buyer realistically raise their income? How will the lengths of the leases impact a buyers underwriting? -Is there downside/upside for buyer? How will this affect price? -Better to use 'last lease signed' rather than asking rents. Take into account concessions and what their leases include -When comparing bear in mind the numbers do not reflect concessions, expense reimbursements, or credit loss differences -Should you underwrite with market vacancy or actual? depends! -When calculating a loss-to-lease, keep in mind this is most applicable to shorter term leases such as apartment buildings

On-Market Comps

-Demonstrates that property is well priced -puts a ceiling on price

Each indicators have their weaknesses...

-Price per unit does not consider the size, type, income, or physical condition -Price per SF does not consider the # of units, type, income or physical condition -Gross Rent Multiplier (GRM) Considers only the Gross Potential Rent (GPR), not the vacancy, expenses, physical condition, or the potential upside due to below market rents -The CAP Rate considers the net income but not the impact of the financing or the potential upside due to below market rents

The key difference between Principal Reduction and Equity build-up is...

-Principle Reduction deal strictly with the reduction of debt and does not consider increases of equity due to an increase in total property value i.e. appreciation -Equity build-up considers both principal reduction and increases of equity due to an increase in the total property value

Expense Categories: (10)

-Real Estate Taxes -Insurance -Utilities -On-site Payroll -Professional Management Fee -Repairs and Maintenance -Contract Services -Advertising/Marketing -Reserves and Replacements -Other Expenses

The importance of sales comparable(s)

-Will need to calculate the Gross rent multiplier (GRM) -Capitalization Rate (CAP Rate) -Cost per unit -Cost per SF -Cash on Cash Return Use these to prospect property and place in appropriate categories

Warnings about Cap Rates are bases on...

1. Actual income and expenses from the prior 12 months 2. Projected Income and last years expenses 3. Projected income and last year's expenses are inflated by 3% 4. Current income and projected expenses 5. Project income and expenses And for each of these, NOI can be calculated differently!

Determining the Maximum Loan and Price for the Property

1. Calculate the maximum supportable annual debt service, divide the NOI by the DCR. 2. Divide the annual debt service by 12 to determine the monthly loan payment 3. Use calculator to solve 4. Divide the maximum loan amount by your previously estimated price to generate your LTV. Verify that that the Max supportable loan amount is less than or equal to the lender's LTV (usually 65%-80%) based upon the value you derived from the price-performance indicators. IF the LTV exceeds the max allowed by the lender, reduce the loan amount to equal the lenders and recalculate the mortgage payment. Remember, Lenders require a loan to support their min DCR while not exceeding their Max LTV. 5. Subtract the Max allowable/supportable loan from your price-performance indicator value to derive the down payment.

There are two forms of leverage

1. Financial Leverage 2. Cash Flow Leverage

3 most common expense tests...

1. Percentage of income= Total Expenses/Effective Gross Income (EGI) 2. Expenses per Unit= Total Expenses/the number of units 3. Expenses per SF= Total Expenses/ SF of rentable area

Expenses fall into 3 major Groups

1. Uncontrollable Expenses 2. Controllable Expenses 3. Reserves and Replacements

Loan Constant (K)

Another Method of calculating debt service payments. The constant debt service, which includes both principal and interest payments, is expressed as a percentage of the original loan amount. The Loan Constant is derived by dividing the annual debt service by the original loan amount and is based upon a given interest rate and amortization period. Annual principal and Interest Payment /Original Loan Amount =Loan Constant

Operating Expenses

Any of several categories of expenses including: Taxes, Insurance, Utilities etc.

Cash Flow Leverage

It is examined at a point in time and is governed by the rate of cash-on-cash returns. While cash on cash returns may be better than the rate of interest on the debt, it doesn't necessarily result in positive cash flow leverage. This examines the amount of monies flowing into an investor's pocket. That is, principal reduction is not considered because it is recognized increase in cash flow, or actual money in the investor's pocket. Need to know the loan constant. An investment is considered to have positive leverage if the Cap rate is greater than the loan constant. The Result of the cap rate being larger than the loan constant is the investors cash on cash will be greater than the CAP rate. Positive Leverage= Cap Rate> Loan Constant Negative Leverage= Cap Rate< Loan Constant Negative leverage results when the cash on cash return is LOWER than the CAP Rate as a result of being financed

Loan Standards

Lenders use two simple tests to determine the maximum amount that they will loan on a property- the Debt Service Coverage Ratio (DCR) and the Loan to Value Ratio (LTV)

Balloon Payments

Loans can be designed with different payment schedules. When the amortization period is longer than the term of the loan, the final payment is called the "balloon payment".

Vacancy/Other Deductions

Losses of income due to vacancy, credit loss, concessions, model units and employee discount units. it is prudent to use the greater of the "actual vacancy" or submarket vacancy when deriving a supportable loan amount.

Reserves and Replacements are...

Money that is set aside for the future replacement of unit appliances, flooring, heating and cooling systems, roofs, parking lots etc. Reserve policies are determined by the property's age, condition, and quality of original construction, as well as market sentiments.

Cash-on-Cash Return

Most investors mortgage their purchases and their initial investment is limited to the down payment. The COC describes the rate of return on their down payment Cash-on-Cash Return= Cash flow (After debt services)/Down Payment

Other Income (Ancillary Income)

Non-rent income, i.e. Laundry, application fees, other miscellaneous sources of income that are related to the operating of the property.

Amortized Loans

One in which the repayment occurs in regular increments that include both interest and a portion of the principle. The principle retired with each payment is called the "Principal Reduction". Though the payment amount remains constant, the percentage of each payment that contributes to the principal reduction increases over time. The equity in the investment is the value of the real estate, minus any loans or other encumbrances.

Price Per Unit

Simple market benchmark derived by dividing the price by the number of units. Conversely you can derive the price by multiplying the number of units by the current market price per unit. -this is unreliable because it does not take into account SF, # of bedrooms, Quality, condition etc.

Effective Gross Income (EGI)

Subtract Vacancy/Other deductions from the Gross Potential Income (GPI) to derive the Effective Gross Income (EGI) +GPI -Vacancy/Other Deductions ____________________________ =EGI

Net Operating Income (NOI)

Subtract the Operating Expenses from the Effective Gross Income (EGI) to derive the Net Operating Income +EGI -Operating Expenses __________________________________ =NOI

Uncontrollable Expenses are..

Such as property taxes, insurance and utilities, are predictable and verifiable. Verify them by reviewing tax bills and having conversations with the local assessor's office, receiving insurance premiums estimates from qualified persons and examining utility statements.

Loss (Gain)-to-Lease

The difference between All Units at Market Rent and the Gross Potential Rent (GPR)

All units at Market Rents

The estimated rental income that could be obtained if the units were vacant and available for rent

Cash-on-Cash Return Plus Principle Reduction

The monthly debt service payments on an amortized loan include both interest and principal. Even though the payment remains constant over the term, with each payment made the portion going towards interest is reduced while the amount directed toward the principal, or the reduction of the amount owed, increases. The amount paid towards the principal is known as the principal reduction. Therefore, the investors equity in the property increases with each payment (assuming the property's value is constant or increases) due to the reduction of the amount owed on the loan Principal reduction + Cash Flow /Down payment =Cash-on-Cash plus Principal Reduction

Gross Potential Rent (GPR)

The sum of the current rent roll of the occupied units and the vacant units at market rent

Measure of Value

The value of an investment property ultimately depends on the returns that it will generate and how those returns compare with those of other currently available investments.

Controllable Expenses are...

Vary with the size age and condition of the property, along with the owner's management style. These include management fees, on-site payrolls, repairs and maintenance, contract services, advertising/marketing, and administrative expenses.

Loan to Value Ratio (LTV)

What the lender will lend a certain portion of the property value, according to their value estimate. Loan Amount /Price =Loan to Value Ratio (LTV)

Debt Service

is the cash that is required to cover the repayment of interest and principal on a debt for a particular period. ... This ratio helps to determine the borrower's ability to make debt service payments because it compares the company's net income to the amount of principal and interest the firm must pay.

Gross Rent Multiplier (GRM)

is the financial ratio used to compare the prices of similar properties most commonly used with hotels/apartments -can be unreliable and dangerous if there is a scarcity of comps -Properties must be similar can have different operating expenses ratios. Many investors prefer other indications of value Value /Gross Potential Rent =Gross Rent Multiplier

Leverage

is the use of credit or borrowed funds to improve one's speculative capacity. One reason that an investor may choose to use debt is that he or she may not have enough equity capital to buy a property. Another reason for using debt is to realize the potential benefits that my result to an investor by borrowing money at a rate of interest that is lower than the expected rate of return on total funds invested in the property. In this scenario, the cost of debt service is cheaper than the anticipated return on equity.