Archive for November, 2010

Debt Service Coverage Ratio (DSCR) is calculated by dividing the mortgage payments by the net operating income. This number is used by banks when deciding whether or not to lend on a property. A DSCR of 1.0 means the net operating income is exactly enough to cover the mortgage payments. Banks generally like to see a DSCR of 1.1 or higher. Some lenders like it to be as high as 1.25.

To increase the DSCR, you could increase the net operating income of the investment. This can be done by increasing the gross rental income or decreasing the operating expenses. A decrease in the interest rate on the mortgage loan will also improve your DSCR.

Let’s use the example from last week. The Net Operating Income (NOI) was $69,000. The mortgage loan payment on the property was $60,000. Thus, the Debt Service Coverage Ratio (DSCR) is 1.15 (69,000 / 60,000). A small decrease in the utilities expenses of only $3,000 would actually increase the DSCR to 1.20 (72,000 / 60,000).

What Is Net Operating Income?

Net Operating Income is a measure of the business’s profitability from operations. It is the Income after deducting operating expenses but before deducting depreciation, amortization, interest and income taxes. It is also known as Earnings Before Interest and Taxes (EBIT).

As an example, let’s look at an apartment building with the following income and expense figures:

  • Gross Rental Income: $160,000
  • Laundry Income: $3,000
  • Management expense: $16,000
  • Utilities expense: $25,000
  • Maintenance expense: $35,000
  • Property Tax expense: $12,000
  • Insurance expense: $6,000
  • Depreciation expense: $45,000
  • Mortgage Interest expense: $60,000

The Net Operating Income would be $69,000 (160,000 +3,000 – 16,000 – 25,000 – 35,000 – 12,000 – 6,000)

Net Operating Income is part of the calculation of the cap rate which we covered last week. It is also used to calculate the debt service coverage ratio (DSCR) which we’ll cover next week.

Capitalization Rate (or “cap rate”) is a ratio used to calculate the value of an investment by looking at the annual net operating income as a percentage of the property’s cost. Cap rate is calculated as Net Income divided by Current Market Value.

For Example: If a building is worth $1,000,000 and has a net operating income of $100,000, then the cap rate is 10% (100,000 divided by 1,000,000.)

You can also use this formula to calculate the value of a property.

Since Cap rate = Net Income / Market Value,
then Market Value = Net Income / Cap Rate.

Thus, if an investor wants a cap rate of 11% on a building that’s generating $80,000 in net operating income, we would value it at $727,272 ($80,000 divided by 0.11)