One of the first and most basic set of formulas an appraiser learns when introduced to the income capitalization approach and direct capitalization, is I-R-V. In this article we will show how this simple valuation formula can be expanded and enhanced to explain other relationships relating to finance as well.
The IRV formulas impart a critical understanding of the relationships between net operating income, capitalization rates, and value. IRV is an example of elegant simplicity as it offers an important understanding of valuation component relationships.
Although the income capitalization courses have aspects of mortgage financing in them they generally do not provide an easy memorable link for future recollection of finance formula similar to the IRV model and valuation. Further, it is my contention that appraisers generally understand finance far better than they think they do and through a simple reapplication of this classic formula they will be armed with a new level of finance relationships.
Accordingly, my focus in this presentation is to reintroduce the typical basic relationships of valuation and finance and then to provide additional relationships that spawn from these building blocks. Through a simple substitution of financial component subscripts with the basic valuation formulas reveal the same critical relationships involved
with mortgage financing.
(See reference of the Table of Symbols)
The practical utilization of the above is that net operating income is equal to mortgage debt service, the overall capitalization rate is equal to the mortgage constant, and property value is equal to the total mortgage amount.
A working example to be will used in this article will be for commercial property that sold for $1,000,000 that had a $70,000 net operating income (7.0% capitalization rate) that was financed at 65% loan to value ratio with a 6.5% fixed rate mortgage that was based on 30 year amortization (7.6% mortgage constant).
The practical utilization and working examples of the substitutions are ….
For many years, the debt service coverage ratio (DSCR) was considered standard metric in commercial real estate lending. DSCR has its limitations as it only measures the relationship of net operating income and annual debt service.
Let’s first look at a few of the flaws of DSCR before we discuss alternative types of metrics. The debt service portion of the calculation (DSCR = NOI / Debt Service) is subject to a couple of variables. Namely those variables used in calculating debt service are A) the interest rate on the loan B) length of amortization. Therefore, by adjusting the interest rate down and lengthening the amortization a much better DSC may be achieved than is otherwise prudent. This is the Achilles heel is DSCR as a sole matrix for loan evaluation.
By understanding that the relationships of valuation and finance are similar with differing components, we can explore the integration of the two to create a more expansive analysis. Accordingly, a natural next step is to utilize a mixture of both valuation and financing symbols in similar relationships to reveal the nature of the real estate term “debt yield” (DY). The practical utilization is stated as follows:
When using debt yield as a benchmark, if the overall debt yield percentage is deemed satisfactory by the lender it suggests that debt service coverage (DSC) and/or the mortgage constant (Rm) in combination are sufficient to account for the prescribed investment risk tolerance. DSCR tests are now often combined with debt yields among other ratios when property is being underwritten. This is the debt yield calculated using the prior examples of appraisal and finance.
The working examples is stated as follows:
So, while NOI is used in both calculations, the loan amount takes the place of the value when we are calculating debt yield. The next logical algebraic extension is the final relationship of debt service coverage ratio and debt yield.
After establishing sufficient yield (mortgage constant) and coverage protection (DSCR) the corresponding debt yield becomes a useful tool for a quick orientation in estimating loan proceeds. A simple way of utilizing the debt yield as an approximation tool is to convert the rate into a multiplier (1/r = reciprocal). This is calculated as, 1/.1077 = 9.28, which translates to 9.28 X $70,000 (NOI) = $650,000 (maximum loan amount) for the above example. We must remember that debt yield requirements and leverage positions will vary by property type and markets.
In summary, as we explored several risk measurements and their associated relationships, we realized that property valuation and evaluating real estate financing have important substitution similarities as well as interdependent associations. It is important to note the significance and impact of the appraiser on the lending process. The common element between them, of course, is establishing a reliable net operating income (NOI). The appraisal art and science of estimating stabilized income and expense on any particular property remain a major tenet of the loan underwriting process.
