Calculating Value and Debt Coverage Ratio using
Net Operating Income (NOI) for investment properties
For commercial properties, different methods of calculating value are used. To make it a little easier, I have outlined below what information is needed and how to calculate each step. I also have a spreadsheet that will calculate everything for you once you have the figures.
Properties with more than 3 rental units are generally considered commercial properties. Qualifying for commercial loans often requires higher documentation and greater analysis of the rental income. Calculating Net Operating Income can help determine the fair market value for these and other investment property types.
Net Operating Income or NOI is equal to a property's yearly gross income less operating expenses. Gross income includes both rental income and all other income associated to the property such as parking fees, laundry and vending receipts, etc. Operating expenses are costs incurred during 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 Possible |
$120,000 | |
|
Other Income |
$ 3,000 | |
|
Potential Gross Income |
$123,000 | |
|
Less vacancy Amount |
$ 2,000 | |
|
Effective Gross Income |
$121,000 | |
|
Less Operating Expenses |
$ 31,000 | |
|
Net Operating Income |
$ 90,000 |
Net operating income or "NOI" 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 $90,000. We would estimate the value of this property like this.
|
Net Operating Income $90,000 |
|
Estimated Value = -------------- = ------------ = $900,000 |
|
Capitalization Rate .10 |
The NOI will enable you to calculate a Debt Coverage Ratio or "DCR." Lenders and investors use DCR to measure a property's ability to pay it's operating expenses and mortgage expense. A debt coverage ratio of 1 is breakeven. Most lenders require minimum of 1.1 to 1.3 to be considered for a commercial loan. From a a bank's perspective, the larger the debt coverage ratio, the better. Debt coverage ratio is calculated like this.
|
Net Operating Income $90,000 |
|
Debt Coverage Ratio = ------------------------------- = ---------- = 2.25 |
|
Debt Service $40,000 |
Debt service is the total of all interest and principal paid on a loan in a given year. It is equal to the mortgage payment(s) times 12.
Net Operating Income is important in several real estate ratios which include the Capitalization Rate, Net Income Multiplier and the Debt Service Coverage Ratio. It is also an essential part of an income property's Income & Cash Flow Statements