Optimizing commercial property, part one
Lenders consider a handful of metrics and ratios to estimate the value of commercial properties. In part one of this video series, learn which ones matter most and how you can calculate them.
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In today’s economy, businesses are looking to reduce cost and strengthen cash flow. The first step is to understand the important metrics and ratios that lenders look for. Hi, I’m Aaron Huberty with Wells Fargo Business Real Estate Financing. In this first part of the Optimizing commercial property videos, we’ll take a look at important metrics and ratios lenders use when working with business owners and real estate investors.
The first key metric a property owner or someone else looking to purchase commercial property should focus on is Net Operating Income, or NOI. Perspective buyers use NOI to estimate the value of the property, and lenders use it to determine how much to lend a prospective buyer. NOI is a simple mathematical equation. It’s gross operating income minus operating expenses. Gross operating income is the total rents collected on a property minus any vacancy in that property or minus a vacancy rate for that particular property type in the marketplace where it’s located. Operating expenses are all expenses for managing and maintaining the property including taxes, insurance, maintenance, supplies, etc.
Let’s look at an example. Let’s say you own a 10 unit apartment building and each apartment rents for 500 dollars. Let’s also assume that the vacancy rate for the apartment building in this area is 10 percent. That means one in every 10 apartments is empty. So the gross operating income is 10 apartments times 500 dollars a month minus the 10 percent vacancy rate which is 4500 dollars a month. This equates to 54 thousand dollars a year. That’s your gross operating income. Now, let’s assume for this property you’ve incurred 35 percent of that as operating expenses. So that equates to about 19 thousand dollars. NOI is simply 54 thousand dollars minus the 19 thousand which equals 35 thousand.
NOI is a very key metric because it is used in two very important real estate ratios. The first one is used to calculate or estimate the value of the property. To do this, one must first understand a concept called capitalization rate, or the cap rate. Cap rate is simply the ratio between the net operating income produced by the investment property and it’s capital cost. Cap rates are usually set by the market, so depending upon the property type you’re looking for, there will be a specific cap rate to be used for that market.
So for our example today, let’s use a cap rate of 10 percent. To estimate the value of the property, it’s already been established that the NOI is 35 thousand. Divide that by the cap rate, 10 percent. That’s 350 thousand dollars, the value of your property.
The second important ratio is what banks look for. It’s called the debt coverage ratio. This is the income generated from the property that allow it to cover the mortgage. Most banks will require a debt coverage ratio of between 1.1 to 1.3. Now the larger the number is, the more comfortable the bank feels about lending you money. How do you calculate debt coverage ratio? A debt coverage ratio is calculated simply by taking your NOI, divided by the total debt service, which is simply all the interest in principal that you pay your bank on your mortgage in a given year.
So to estimate the debt service, let’s go back to the example. The estimated price we came up with was 350 thousand dollars. Most banks will lend you 75 percent of that value, which is 262 thousand, five hundred dollars. Now the remainder of it you have to bring in cash for a down payment. Let’s assume a bank is willing to give you a loan for 4.5 percent with an amortization over 15 years. That equates to a monthly principal and interest payment of approximately 2000 dollars or a total debt service of 24 thousand dollars for the year. That calculates to a ratio of 1.45, a very good number. Well above the 1.1 to 1.3 minimum. Now, one important fact you need to understand is as NOI deteriorates, the debt coverage ratio will also drop, making it harder for you to be able to secure the size of loan you need.
Now that you understand those ratios, let’s move on to three other things real estate buyers should remember. First, just like when you’re shopping for a home, location matters. Second, conduct your due diligence. Finally, use the current NOI and cap rate to calculate the property value. Some markets may command a higher price for the property, but this calculation provides a good guideline as to what the property is worth today. Remember, there are two ways to optimize your investment property. You either increase your rental income or you reduce your operating costs.
Thank you for joining us for this segment of the Wells Fargo Business Insight Series. To learn more about how Wells Fargo Business Banking can help you, visit wellsfargo.com/biz. In the meantime we wish you continued success.
Get more information about Business Real Estate Financing here.