and the investor purchased the property for $100,000 cash, the investor’s cash-on-cash return (before taxes) is 10 percent ($10,000 divided by $100,000). NOI represents the maximum amount of funds available to ser- vice debt on the property should you desire to finance the property with a mortgage. For instance, the NOI of $10,000 could pay the mortgage on a $124,000 mortgage assuming a 30-year amortization period and a 7 percent interest rate, or it could fund a $150,000 note over a 15-year period at a 0 percent interest rate. Do you see how important this figure can be in the negotiation of the terms related to the purchase of real estate? We will be exploring this concept in more detail in future articles.
A traditional lending institution will utilize a property’s NOI to estimate the property’s debt service coverage ratio (DSC). The debt service coverage ratio is the ratio between a property’s annual NOI and the property’s annual debt service. A DSC of 1 means that there is exactly enough NOI to support your annual debt service and not a penny more. A DSC of less than 1 indi- cates that the NOI is not sufficient to cover your debt service, while a DSC of more than 1 indicates the NOI is sufficient to cover your debt service with additional funds remaining. DETERMINING PROPERTYVALUE NOI determines the value of the property in question when applying a capitalization rate, or cap rate. A cap rate is defined as the anticipated rate of return produced by a real estate investment. THE FORMULA FOR CALCULATING CAP RATE IS: Cap Rate = NOI / Purchase Price Thus, if the NOI is $10,000 and the purchase price is $120,000, then the cap rate is 8.33 percent ($10,000/$120,000). In short, NOI is an objective measure of a property’s income stream, while the cap rate is a subjective measurement of how an investor’s capital must perform at a point in time. We will explore the concept of cap rates in detail in a future article. NOI represents the starting point for the question, “Howmuch did I make this year?” This begins to get us into the discussion of taxable income, which is calculated as follows:
NOI - INTEREST ON MORTGAGE DEBT PAID - DEPRECIATION
- AMORTIZATION OF POINTS AND OTHER COSTS
NOI Minus interest on mortgage debt paid Minus depreciation Minus amortization of points and other costs Equals taxable income (loss) = TAXABLE INCOME (LOSS)
NOI is one of the most important calculations a real estate investor can make, as it is at the heart of so many other cal- culations that provide the investor with an indication of the expected performance of the property. These calculations can then be compared to other real estate investments in order to select the investment that best meets the return requirements of the individual investor. • Carter Froelich, CPA, is the founder of The Property Ledger™, a Web- based real estate investment software. To get a free 30-day trial of The Property Ledger™, visit the website at www.thepropertyledger.com.
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