Chapter 20: Commercial and Investment Properties 2

Net operating income (NOI)

Annual income from a property or business that remains after annual operating costs are paid. Does not take into consideration any expenses associated with the financing of property. One of the first indicators of the real value or worth of an investment. Most important component in valuing income-producing property. NOI measures the ability of an investment property to produce an income stream or cash flow from its operations.

Positive leverage

Borrowed funds are invested at a rate of return higher than the cost of those funds to the borrower, resulting in a profit on the borrowed funds.

Negative leverage

Borrowed funds are invested at a rate of return lower than the cost of those funds to the borrower. Investors incur a loss on the borrowed funds. ex. Interest rate charged by the lender for the borrowed funds is greater than the rate of return the investment is generating on those borrowed funds.

Capital rate method

Estimate the present value of future income. IRV formula: Income NOI Rate (capitalization rate): Amount of return the investor expects to earn from the investment. Value of the property Income (NOI) / / Rate X Value

Effective Gross Income

Estimated rental income the owner anticipates collecting and that will be available to pay the expenses of owning a property.

Variable expenses

Expenses that are necessary to maintain the income stream of the property and provide services to the tenant.

Fixed expenses

Expenses that occur in regular basis, have regular payment amounts such as property tax and insurance, landscaping, and other service contracts. Generally do not vary in response to changing the levels of occupancy.

Cash flow model

Investors use this model to prepare a pro forma

Depreciation

Loss of value to a property over the time during which it is expected to be useful.

Cash flow

Measurement of both income and expense items associated with operating the property. Cash flow before taxes is the gross amount of income available before considering taxes.

Reserve for replacements

Money that a property owner sets aside regularly in anticipation of needing to fund capital improvement projects or to pay for extraordinary repairs.

Cash on cash return " cash in on cash out"

Ratio of income generated by the property to the cash investment in the property. Before tax cash flow / purchase cost = cash on cash return Ex Page 493

A potential buyer would be more interested in determining the economic rent ("Market Rent")

Rent that would be possible to charge if adjusted to appropriate market levels.

Type of depreciation can also be called cost recovery

Residential investment property: 27.5 years Commercial property: 39 years

Financial risk

Results when debt is used to finance an investment.

Capital market risk

Risk that changes in the market for capital will affect the value of real estate. Is affected by changes in the level of interest rates, changes in the availability of mortgage and equity capital, and changes the rate of return for alternative investment opportunities.

Space market risk

Risk that the demand for space will affect rents, vacancy rates, and net operating income (NOI)

Pro forma "Annual property operating date (APOD)"

Shows the hypothetical projection of income and expenses for this first full year of ownership. Start by requesting a copy of the present owners recent tax returns and/or their operating statements.

Liquidity

The ability to convert an asset into cash quickly without the loss of principal.

Marketability

The ability to quickly convert a commodity into cash at any price.

Risk

The degree of probability the actual rate of return earned will differ from the return expected when the investment was made. Low risk investment are expected to generate low profits. High risk investment are expected to generate high profits

Leverage "Use of other peoples money (OPM)"

The effect borrowed funds have on investment returns.

Gross potential income "Gross Revenue"

Total income, both cash and non-cash, received from an investment or business before any expenses are paid or losses accounted for.

Operating statements

Used by property owners to illustrate total revenues generated and expenses for a given period as a means of evaluating the properties performance.