Part 3 Unit 10

Operating expenses --

cash expenditures made to maintain and operate the property.

Cash-on-cash return is revealed by dividing cash flow by

cash invested.

technical default

defaults of a non-monetary nature

Gross operating income --

effective rental income amount is adjusted to include income from other sources.

If an investor requires a given return on an existing investment property, the analyst would be compelled to

identify the required price in view of its existing net operating income.

Total debt service

includes principal and interest payments for all loans on the property.

The capitalization (Cap) rate

is designed to reflect the recapture rate of an investor's original investment over the economic life of the investment to give an acceptable rate of return on the investment.

Annual debt service

is the annual amount of principal and interest paid to a lender to service the mortgage loan on the property.

NOI is affected by _____.

market, rent, vacancy

Taxable income--

net operating income minus all allowable deductions, including the amount allowed for annual depreciation on the property and interest expenses.

NOI

net operating income-used to determine the profitability of a property

Property Operating Statement--

presents cash flows from operations plus non-operating cash flows, such as debt service, income taxes, and capital expenditures.

Market rent—

price a property is likely to achieve in current conditions.

To calculate the debt service coverage ratio,

simply divide the net operating income (NOI) by the Annual mortgage payment(s). For the sake of simplicity, let us assume that there is only one mortgage on the property. $500,000 First Mortgage 11% Interest, 30 years amortized Annual Payment (Debt Service) = $57,139 Then: Net Operating Income (NOI) of $65,000 / Total Debt Service of $57,139 = DSCR of 1.14

cash flows

the dollars, before or after taxes, received and paid out by an investor or property operator.

Debt service

the principal and interest payments made on a debt over a period of time; Debt service is subtracted from net operating income to get before-tax cash flow.

Gross rental income (gross income) --

the revenue a property would generate if it had no vacancies.

term default of the loan

the risk of default during the term of a loan, from loan origination through loan maturity

Debt Service Coverage Ratio -

used to determine if the property is able to cover the mortgage and all other expenses tied to the property. Calculated by dividing net operating income by total debt service

Expenses

variable: fluctuate with occupancy; fixed: incurred whether property is occupied or not.

A property earns an annual NOI of $120,000. Its owner uses a cap rate of 8%. What is the property's value, according to the income capitalization method

$120,000 / .08 = $1,500,000

Effective rental income

-- gross rental income amount is adjusted to reflect vacancy losses.

What factors help to lower the risk of default in commercial mortgages?

1. collateral value higher than the loan amount 2. The borrower has significant cash equity in the property and has incentive to keep the loan current 3. The property is well managed by an experienced property manager; 4. property is located in a desirable market 5. The property is fully leased by credit worthy tenants 6. property cash flow generated exceeds the payments of the proposed loan by a sufficient margin to protect the lender from fluctuations in that cash flow due to unexpected economic and market events 7. The loan is structured such that, depending on leverage, it either fully amortizes or has some level of amortization over its term, has reserves for re-leasing and capital expenditures, and employs other forms of credit enhancements appropriate to mitigate certain risks.

A property has a Cash Flow Before Tax of $200,000 and a Cash Flow After Tax of $140,000. The investor invested $750,000 in the property. What is the Cash-on-Cash Return, before taxes? For the property described in Question 1, what is the Cash-on-cash return after taxes?

200,000/750,000 = 27% 140,000/750,000 = 19%

Income Tax Liability

An investor's tax liability from a property is based on taxable income rather than cash flow. Taxable income is net operating income minus all allowable deductions, including the amount allowed for annual depreciation on the property (also cost recovery)

How is an investor's tax liability derived?

An investor's tax liability from a property is based on taxable income rather than cash flow. Taxable income is net operating income minus all allowable deductions, including the amount allowed for annual depreciation on the property.

What is before-tax cash flow? CFBT

Before-tax cash flow is the measure of the cash received after the net operating income has been calculated and any mortgage-related expenses are paid, but before taxes are taken into consideration.

Which of the following items are not deductible in deriving taxable income? A.Utilities B.Depreciation C.Loan principal payments D.Property taxes

C. Loan principal payments

How does the notion of market rents affect investment analysis of a property? A. Increasing market rents can cause an oversupply of space in the market. B. Changes in market rents raise or reduce a property's total rental income. C. They directly impact the existing rent roll of a building. D. They do not significantly impact investment analysis.

C. They directly impact the existing rent roll of a building.

Calculating Cash Flow After-Tax CFAT

Cash Flow After Tax is simply Cash Flow Before Tax minus the tax liability. If the investor above with the $2,800 tax liability had a before-tax cash flow of $24,000, the after-tax cash flow would be $21,200. CFBT $24,000 Less Tax liability -$2,800 CFAT $21,200

Debt Coverage Ratio

Debt coverage ratio measures the investor's ability to pay the property's monthly mortgage payments from the cash generated from renting the property. It is calculated by dividing the annual net operating income (NOI) by the annual debt service. Lenders use this ratio to determine whether the property will generate enough cash to pay rental expenses plus the loan payment.

Which of the following are variable expenses on an income property?

Gas and electric expenses

numerator

In calculating DSCR, considering that net operating income is the income from a rental property left over after paying all of the operating expenses, this is how it works: Gross Scheduled Rents Less 5% Vacancy & Collection Loss $100,000 $ 5,000 Effective Gross Income: $ 95,000 Less Operating Expenses Real Estate Taxes Insurance Repairs & Maintenance Utilities Management Reserves for Replacement Total Operating Expenses: $ 30,000 Net Operating Income (NOI) $ 65,000

Which of the following best characterizes 'potential income'?

Income before vacancy

Calculating cap rate

Income ÷ Rate = Value If a property earns NOI of $50,000 per year and the investor's Cap rate is 9%, the value of that property is $555,555. $50,000 ÷ .09 = $555,555

What does the total debt service include?

It includes the principal and interest payments of all loans on the property.

For what is debt service coverage ratio used, and what is the formula for calculating it?

It is used to determine whether a property is able to cover the mortgage and all other expenses tied to the property. It is calculated by dividing the NOI by the total debt service.

List two examples of variable expenses.

Management fees, Utility expenses

Name three factors that affect net operating income.

Market rent , Vacancy, Expenses

Maturity Risk

Maturity Risk is the risk of default at the date when a loan is due.

Effective Gross Income minus Total Operating Expenses = DSCR. Total Debt Service. NOI. annual payment.

NOI

The formula for calculating the DSCR is

NOI / annual payment.

taxable income calculation

Net operating income - Depreciation - Interest Expense = Taxable Income Taxable income multiplied by the investor's marginal tax bracket gives the investor's tax liability. For example, if an investor has a taxable income of $10,000 and is in the 28% tax bracket, the tax liability for that investor will be $2,800. $10,000 x .28 = $2,800

A property has a potential rental income of $90,000. The vacancy for the year resulted in $17,500 in collection losses. The property had operating expenses of $44,000. What is the net operating income for this property?

Potential Income $90,000 Less Vacancy and Collection Losses - $17,500 Effective Income $72,500 Less Operating Expenses - $44,000 Net Operating Income $28,500

List three examples of fixed expenses.

Real estate taxes, Insurance premiums, Advertising

The vacancy rate affects income property analysis in which of the following ways?

Rising vacancy decreases net income.

Cash Flow Before Tax. CFBT

Subtracting debt service from the NOI produces Cash Flow Before Tax.

Tax liability--

Taxable income multiplied by the investor's marginal tax bracket

List the three types of default and briefly explain each.

Term default is a default that happens during the life of the loan. Maturity default is when the default happens at the loan's maturity or when it is due, such as the borrower being unable to obtain refinancing to pay off the loan. Technical default is a default of a non-monetary nature, such as not carrying adequate insurance.

debt service coverage ratio

The DSCR is defined as the monthly debt compared to the net monthly income of the investment property in question.

What is loan to value used for?

The LTV is used to determine what percentage of the property is being financed

Cash Flow After Tax

The after-tax cash flow is the profit that the investor actually receives from income-producing property after the income taxes are paid. It is the cash flow before tax, minus the tax liability.

What is gross rental income?

The amount of revenue a property would generate if it had no vacancies.

Define cash flow.

The cash received minus the cash paid out over a given period of time

What does a debt coverage ratio measure?

The investor's ability to pay the property's monthly mortgage payments from the cash generated from renting the property.

In addition to the demographic makeup of the population and the median income of families in a particular area, what will the market rents for retail space depend on?

The percentage of income families in the area usually spend on the purchase of goods and services from the retail companies in their area.

Break-Even Ratio

This calculation shows the percent of gross income that is required to meet cash expenditures. It is calculated by adding debt service to operating expenses and dividing by operating income. Too high a break-even ratio would cause a lender to have some doubts.

Operating Expense Ratio

This is the percentage of effective gross income that is consumed by the operating expenses. It is calculated by dividing the operating expenses by the effective gross income. Usually, the lower the ratio, the more efficient and profitable the property is.

Return on Equity

This is the ratio of cash flow to equity: CFAT ÷ Equity = ROE In the apartment example, let's say that equity is the difference between the $1,500,000 price and the $600,000 loan amount, or $900,000. The property had a Cash flow After Tax of $109,273, so the ROE is $109,273/$900,000, or 12%. ROE measures the investment's rate of return on owner equity. This measure will decrease as the owner pays down the loan principal thereby increasing equity in the property

Return on Investment

This is the ratio of net operating income to price: NOI ÷ Price = ROI Thus, if our $1,500,000 apartment complex is generating an NOI of $240,000, the ROI is 240,000/1,500,000, or 16%. ROI measures the overall profitability of the investment regardless of financing. ROI will fluctuate as a function of increasing or decreasing NOI

What is a capitalization rate designed to do?

To reflect the recapture rate of an investor's original investment over the economic life of the investment to give that investor an acceptable rate of return on his or her investment.

Thorough underwriting designed to avoid default risk focuses on four key areas:

a. The economic strength and supply and demand dynamics for other properties in the market in which the collateral property operates; b. The competitiveness of the collateral property in its market and its ability to generate cash flow to pay debt service during the term of the loan and be refinanced upon maturity; c. The equity contribution and management expertise of the borrower/sponsor; and d. The structure of the proposed loan to minimize and mitigate known risks.

Thorough underwriting designed to avoid default risk focuses on four key areas. Which of the following is NOT one of those areas? A. The structure of the proposed loan to minimize and mitigate unknown risks B. The economic strength and supply and demand dynamics for other properties in the market in which the collateral property operates C. The competitiveness of the collateral property in its market D. The equity contribution and management expertise of the borrower

a. The structure of the proposed loan to minimize unknown risks

Pre-tax cash flow differs from net income insofar as it

accounts for a property's financing.

cash on cash return

also called the equity dividend rate, is the ratio of annual Cash Flow Before Tax to the total amount of cash invested, expressed as a percentage.

Depreciation—

an annual deduction allowed by tax laws for loss of asset value.

Vacancy-

available space, or percentage of existing space that is unoccupied.