Annual Debt Service: is expressed as Net Operating Income (NOI) divided by the Debt
Capitalization Rate: (Cap Rate) Net Operating Income (NOI) divided by the property’s
purchase price. A principal advantage of using the cap rate is its simplicity of
calculation. It also accounts for vacancy and credit losses and operating expenses.
However, its simplicity also limits its reliability, since the cap rate does not
consider financing or tax impact. Also, it only looks at a one-year forecast when
determining value or measuring performance. Yet even though a one-year income forecast
is used, the investor can select a cap rate reflecting change in income and/or property
value beyond one year.
Cash on Cash Return: Before–tax cash flow divided by the capital invested in the
property. It’s a method to determine how “efficiently” capital invested in the property
Discounted Cash Flow: Analysts use discounted cash flow to explore the time value
of money. Essentially, money today is worth more than the same amount of money tomorrow.
Points and Loan Costs: A discount point is a one-time charge equal to 1 percent
of the loan amount. Charging discount points does not affect the payment schedule
or any balloon payments. Discounts points are either paid separately by the borrower
as a fee at loan closing or deducted from the gross loan proceeds. Either way, discount
points reduce the lender’s net investment amount thereby increasing the lender’s
Debt Coverage Ratio (DCR): Net Income divided by annual debt service (ADS). DCR
is used to measure an investor’s ability to make the property’s monthly mortgage
payments from the cash generated from the property’s rental income.
Depreciation: Also known as “cost recovery” allows for the cost of a property to
be deducted over a period of time. The 1986 Tax Reform Act lengthened the cost
recovery period for residential (which includes multifamily) to 27.5 years and 31.5
years for commercial property.
Effective Rental Income is Gross scheduled income (GSi) minus vacancy and credit
Gross Rent Multiplier (GRM): Is the investment value of the property divided by
year one of its Potential Rental Income (PRI) It can measure an investment’s performance
assuming a given price. Used in this manner, the GRM indicates how many times the
purchase price is multiplied by the first-year PRI.
Gross Scheduled income (GSI): (can also be called potential gross income) are the
total income due under all existing leases.
Gross Operating Income (GOI): (can also be called effective gross income) Gross scheduled
income - vacancy and credit loss
Gross scheduled income
- Vacancy and credit losses
= effective rental income
+ Other income (collectable)
= Gross Operating Income
Internal Rate of Return (IRR): IRR measures the average rate of return the investment
is expected to yield over its life, and fully answers the four basic questions about
any investment decision:
- How many dollars go into the investment?
- When do the dollars go in?
- How many dollars come out of the investment?
- When do the dollars come out?
However, IRR is, as its name implies, an internal rate of return because it only
measures the dollars in the investment for the time they are in the investment. Therefore,
it does not take into account any external factors that affect the dollars taken
out of the investment.
Loan-To-Value (LTV): is the ratio of the loan amount borrowed to the appraised value
of the property, and is expressed as follows: loan amount/property value = LTV ratio.
Mortgage Insurance Premium (MIP): Mortgage insurance is an insurance policy where
your mortgage lender is protected against the value of the outstanding mortgage liability
in the event that you die or are disabled, and are unable to make mortgage payments.
The typical beneficiary of the policy in this case is the bank. Since there may be
cases where you require mortgage insurance either due to the requirement of your
lender, or as a personal preference, you may want to go over some common queries
related to mortgage insurance premiums listed below. MIP is typically calculated
as a percentage of the loan amount being borrowed. MIP varies on the basis of factors
such as the borrower’s credit rating, the down payment being made, whether the mortgage
is fixed or variable, debt to income ratios, etc. Generally, the range of the rates
is between 0.50% and 0.90% of the loan value, with the calculation being based upon
monthly premium payments.
Mortgage Constant or Loan Constant: The mortgage constant expresses the relationship
between the loan balance and the annual debt service (ADS). The mortgage constant
is the percent of the loan balance paid each year in ADS—which is typically both
the principal and the interest. Although the amounts of principal and interest change
as each payment is made, the total amount of debt service stays the same for the
life of the loan—hence the term “constant”.
Net Operating Income (NOI): NOI is the annual income generated by an income-producing
property after collecting all income from operations, such as rentals and other uses
of the property by others, and deducting all expenses required to operate the property.
The assumptions and judgments made in calculating NOI greatly affect the decision
to invest in a given property and at what price. Lenders use NOI to determine loan
amount, investors to determine what they will pay, and appraisers to determine market
The four basic components of NOI are:
Potential rental income (PRI)
Vacancy and credit losses
NOI is calculated as follows:
Potential Rental Income
− Vacancy and credit losses
= Effective Rental Income
+ Other Income (collectible)
= Gross Operating Income
− Operating Expenses
= Net Operating Income
Potential Rental Income (PRI): is the total of all rents under the terms of each
lease, assuming the property is 100 percent occupied. If a property is not yet leased,
PRI is based on market rents as determined from comparable properties. This is the
first value to input into the NOI formula.
Vacancy and Credit Loss: Vacancy and credit losses are income lost due to vacancies
and/or tenants defaulting on lease payments. Data on such losses can be found in
existing leases, which specify when each lease expires, or from vacancy and credit
losses of comparable properties when rented at market rents (which may be affected
by market trends).
To calculate vacancy and credit losses:
- Determine competitive market rents in the area.
- Review the rent history of the property.
- Assess the availability of alternative space.
- Establish vacancy rates for the particular market.
- Review the length of existing leases and lease guarantees.
- Assess tenant quality, economic strength, and current lease satisfaction