Something to Think About #40 – Uncle Sally’s Nephew, Part 3 – By Klarise Yahya, Commercial Loan Broker, BRE: 00957107- MLO: 249261

What we hope to do with this article is to explore a way to quickly estimate the value of an apartment building.  Quickly means before the water boils. Estimate means that we’re not doing a formal appraisal, but we are ballparking the value. The process we’ll be using works on non-residential properties as well, but our focus today will be on apartments because that is what most of us are interested in.

We want to develop our own estimate of value simply to confirm or reasonably dispute the broker’s conclusions printed on his marketing sheet. It is an if-then process: if the data on the sheet is accurate, then the value should be (fill in the blank). If it is not true, then the value would reasonably be different.

The process is not the same as due diligence. Due diligence seeks to confirm every material element of the purchase. At this point we seek only to be comfortable with (a) the net income stated on the broker’s sheet, (b) the building’s ability to service the new mortgage, and (c) whether building is affordable.

Income means Net Operating Income (NOI). The NOI can be inflated by minimizing the building’s expenses. Realize that you will not be inheriting the seller’s expenses, you’ll have your own and they will almost certainly be higher. As only one example, the seller is paying property taxes based on his purchase price back in 1979. Your taxes will be higher. So the thing to watch out for in the Income column is what percentage of the gross goes towards expenses. You want it to reflect your likely costs, not the seller’s.

The new mortgage will be based on the building’s estimated NOI. Conceivably, a prospective buyer could agree to a multi-million dollar purchase price but if the rents will only support a $600,000 loan, well, she’ll have to make a really big down payment. So before the prospective purchase gets too far along, it’ll probably be useful to figure out the maximum loan the building will support.

Affordable means our funds are sufficient for the down payment.

To arrive at these three conclusions we’ll have to estimate the probable Net Operating Income, compute the Debt Coverage Ratio, and finally apply the Dollars per Thousand (from the chart provided) for whatever the current interest rate is. It may not seem possible right now, but with only those three numbers – NOI, DCR, and $/K – you’ll be able to do a rough analysis of any apartment building in a matter of moments. You will find: 

• The maximum loan the building will support
• The down payment
• A reasonable purchase price, given market conditions
• The monthly cash flow to borrower, and
• The cash-on-cash yield on the investment 

Gross Scheduled Income: The Gross Scheduled Income is all the money the building would generate in one year. Everything starts with the GSI. First an allowance is taken for vacancy and credit losses, then deductions are taken for fixed and variable expenses. If there was no mortgage the entire NOI could go straight into your purse. If you have a mortgage, the payments come out of the Net Operating Income.

The lender requires the building’s NOI to generate enough net cash flow to (a) make the amortized principle and interest payments and (b) provide at least a little cash to the borrower each month just to keep her interested. That’s important: the entire NOI is budgeted to only two items, loan repayment and cash flow. If you know the NOI, it is a simple matter to subtract the debt service to arrive at the cash flow. Alternatively, if you subtract the cash flow you will get the debt service.

Net Operating Income (NOI): When first considering a potential purchase, NOIs have to be estimated. While we might use the broker’s gross income figures (subject to verification), we don’t use the broker’s expense figures as there are just too many ways to bias the conclusion.  Instead, we use a carve-out of 40% of the estimated Gross Schedule Income. In reality, expenses may not be quite that much. Perhaps only 30% or 35% of the GSI might go towards vacancy allowance and the fixed and variable expenses, leaving the balance available for debt service and cash flow. But just to be safe we forecast a 40% vacancy and expense ratio. Better to be safe than surprised. Typically, expense ratios decline over time because Net Income tends to grow a little faster than the expenses.

Debt Coverage Ratio (DCR): The lender will not permit the entire NOI to be used for mortgage payments. The Debt Coverage Ratio reveals how much of the NOI can be used to service the debt. DCRs are expressed as a three-digit number, with a “1” to the left of the decimal and two digits to the right. The three most common DCRs are 1.20, 1.25, and 1.50. The number to the left of the decimal is a whole number representing the mortgage payment.

Borrower’s Cash Flow: The two numbers to the right of the decimal represent the buyer’s initial cash flow. DANGER, WILL ROBINSON! This is not what it appears! It might seem like a 1.25 DCR would provide the borrower with a cash flow of 25%, but that’s not how it is.

This is how a person figures cash flow. Ask yourself how many times do the two digits to the right of the decimal (ex: 25) go into the three digit DCR (ex: 125). If you do this right, your answer will be a whole number. We can then easily turn the whole number into a decimal or fraction if we wish.

To continue the example, how many times does 25 go into 125? It goes 5 times. Do you want to turn it into a decimal? One-fifth is 20%. Voila! The borrower’s cash flow is 20% of the NOI.

If the DCR were 1.20 . . . 20 (the number representing the borrower’s cash flow) goes into 120 six times. The borrower can expect an initial cash flow of 1/6, or 17%

Should the DCR be 1.50, the borrower’s cash flow would be one-third (33%).

While it may appear desirable to have as high a cash flow to the borrower as possible right from the close of escrow, the fact is that the higher the cash flow the less remains to service the mortgage. Remember, the borrower’s cash flow comes out of the NOI leaving less for debt service. Everything else being equal, a 1.20 DCR will provide a higher loan amount than a 1.50 DCR, but it’s a tradeoff: a higher loan amount means a more expensive building; a higher cash flow means more shoes.

Cash Available for Mortgage: The mortgage payment cannot exceed NOI minus borrower’s cash flow. The easiest way is to divide the entire NOI by the DCR. For example, $10,000 NOI divided by 1.20 equals $8,300 (rounded) available for debt service.

Dollars Per $1,000: Ok, we know the maximum payment.  Now it’s time to determine how big of a loan that payment would support.

The way some people used to estimate the loan amount, back in the day, was by referring to the published $ per K tables. The tables are not exact but they still work well for estimating the loan amount.  A financial calculator is not required. You can use the simple calculator app on your smart phone. A sample table follows:

This is one way to use the chart to find a maximum loan amount. (a) Monthly NOI divided by DCR equals maximum payment. (b) Divide the maximum payment by the $/K associated with the current interest rate. (c) Multiply by 1,000.

Example: (a) $10,000 NOI divided by 1.20 equals $8,300. (b) $8,300 divided by 5.37 (look in the Dollars per $1,000 column, if the interest rate was 5%) equals $1,546. (c) multiply by 1,000 to get $1,546,000.

Alternatively, if we knew the loan amount (say, $900,000) and we sought only the payment at a 5.5% interest rate, we would do the following: $900,000 divided by $1,000 equals 900 times 5.68 equals $5,112.

The beauty of this little gem is that you don’t have to memorize the chart. If interest rates were 4.5%, it is only necessary to remember that the Dollars per $1,000 at that rate is a little over $5. Remember, this entire process is a rough estimate to determine if the building under consideration could be a purchase candidate.

Example Field Work: Using the 1.20 DCR program and given that the borrower knows a little about local rental rates (or has a worthy broker who does), what can she learn about a building just from a drive-by exterior inspection and a moment of thought, perhaps during a red light, while repairing her lipstick?

Building: It’s an attractive building with no obvious deferred maintenance. Granted, the inside hasn’t been inspected yet, but often the individual units mirror the building’s exterior condition. So it’s probably overall in pretty good shape.

There are 11 utility meters at the side of the building, so we can expect ten units (figuring one meter is for the exterior lights).  The number of meters shows that the building is not master metered, which is a good thing. Right there at the side is parking for 20 cars, and that would probably be consistent with two-bedroom units.

NOI:  In this area, two bedroom units in reasonable condition typically go for about $1,700 a month or a little more. Given that there are 10 permitted units, the Gross Scheduled Income (GSI) should be around $17,000 monthly ($1,700 times 10 units). Probably 40% (or maybe a little less) of that goes for the building upkeep and reserves, so the NOI is about $10,000 a month.

Debt Service: If the NOI is $10,000 monthly and the DCR is 1.20, the maximum debt service would be about $8,300 monthly ($100,000 annually). The math is $10,000 divided by 1.20.

Cash Flow: The borrower’s monthly cash flow would be $1,700 ($20,000 annually).  The math is $10,000 minus $8,300 debt service equals $1,700.

Loan Amount: The borrower knows that current rates are about 5% and the $/K would be $5.37. But the borrower is realistic and knows that rates are trending up, so she reminds herself that this is just an estimate.  

We saw earlier (Debt Service) that this building will support an $8,300 monthly mortgage debt. If monthly debt service is $8,300 and $5.37 will handle $1,000 of debt, then this building can carry a mortgage of about $1,500,000. The math is $8,300 divided by $5.37 equals 1,545 multiplied by $1,000 equals $1,500,000 (rounded).  

Purchase Price: The last several years has established a “new normal” down payment of 30% or more. Presuming a 30% down, the loan would represent 70% of the purchase price. $1,500,000 divided by 0.70 equals $2,150,000 (rounded).

Down Payment: Forecast purchase price ($2,150,000) minus the projected loan is $1,500,000 leaves a down payment of $650,000.

Borrower’s Cash Yield: Borrower puts $650,000 down and receives $20,000 a year cash flow ($1,700 times 12 months equals $20,000 annually.) Cash flow ($20,000) divided by down payment ($650,000) equals an initial cash-on-cash yield (3.0%).

With only a brief inspection and the calculator in any smart-phone we’ve completed a pretty thorough outline of this investment.

Using the basic smart-phone calculator, we’ve estimated: 

• The maximum loan the building will support
• The down payment
• A reasonable purchase price, given market conditions
• The monthly cash flow to borrower, and
• The cash-on-cash yield on the down payment.           

Pretty good for using only the NOI and the DCR and remembering the $/K figure for one single interest rate, huh? And the water isn’t even boiling, yet. 

This article is for informational purposes only and is not intended as professional advice. For specific circumstances, please contact an appropriately licensed professional.Klarise Yahya is a Commercial Mortgage Broker. If you are thinking of refinancing or purchasing five units or more, Klarise Yahya can probably help. Find out how much you can borrow. For a complimentary mortgage analysis, please call her at (818) 414-7830 or email [email protected] 

If you’ve missed some of the prior articles, basic guidelines on successful investing are in my book “Stairway to Wealth” available at LuLu.com.