Commercial Real Estate Cash Flow and Valuation
By Dan Taylor, Executive Vice President Scott Valley Bank, Northern Region
In these trying economic times of reducing lease/rent rates and increasing operating costs, understanding the accuracy of your Net Operating Income (NOI) is imperative. The primary reason is that the NOI drives the value of your property. My point in this article is to not go into the minutia, but to give a simplified and general overview of NOI and how it drives the valuation of your property.
First of all, there are three primary ways of valuating commercial real estate:
Income Approach: This method takes the NOI cash flows and then applies an investment rate (capitalization rate) to calculate a value
Replacement Cost Approach: This method calculates what the actual cost would be to “replace or rebuild” the property if needed.
Market or Comparable Approach: Properties that are similar to your property that have recently sold are used to get an approximation of value.
As stated, NOI is the primary driver that your banker uses to determine the final Debt Service Coverage (DSC) ratio and estimated valuation in regards to the Income Approach.
NOI is defined as the difference of all recurring rent/lease/other income minus all recurring cash operating expenses (i.e. taxes, insurance, etc.) NOI does not include any noncash expenses such as depreciation, amortization or nonrecurring income or expenses.
NOI is then used to determine the DSC ratio. The DSC ratio is calculated by taking the annual NOI and dividing by the annual debt payment (principal and interest). The minimum DSC ratio that most banks accept is 1.25 to 1.00. The easiest way to understand this ratio is for every $1.00 of debt payment, you have $1.25 in NOI to cover the payment. The higher this ratio, the better for you and your bank. The remaining NOI after making your debt payments is the cash that flows to the owners/investors to calculate their return on investment.
NOI is also one of the approaches (Income Approach) used to calculate the value of the property. Simply, the NOI is divided by the Capitalization Rate. The Capitalization Rate is the estimate of an investment return desired by the owners or investors.
For example, if your commercial property generated $40,000 in recurring income and $15,000 in recurring expenses, the Net Operating Income would be $25,000. If your annual debt payment (principal and interest) on a $200,000 loan at 5.0% with a 25-year amortization was $14,000, you would divide NOI of $25,000 by the $14,000 annual debt payment for a Debt Service Coverage Ratio of 1.78 to 1.00 or you could say that for every $1.00 of debt payment your would have $1.78 of NOI to cover the payment.
To estimate the property value, you would take the Net Operating Income of $25,000 and divide by the Capitalization Rate (we will use 8.50%, but this rate needs to be determined by the investors), the estimated value of your property would be $294,000. Dividing the value of $294,000 by the loan balance of $200,000 would equate to a Loan-to-Value of 68%.
With the current market environment of declining rents and increasing capitalization rates, values are declining. As shown above, this results in a declining Net Operating Income. So to make the obvious statement, anything that can be accomplished to maximize NOI will thus enhance the value of your property and your return on investment.
Again, this is a very basic discussion and there are other factors that would need to be addressed. Please contact your relationship banker and your accountant to discuss your particular property.