In commercial lending, it is important to understand and know how to evaluate the income of a commercial property.  Today I am going to go over some basics on evaluating income on a commercial property.

There are two basic foundations for evaluating a commercial properties income.  You have contract rent and market rent.  Contract rent is the portion of gross income from the rent as outlined in the lease or rental agreement.  This is the actual rent collected.  Market rent is the reasonable rent you can expect if the property is available at the time of evaluation.  This is what would be paid on the open real estate market, and is based on current rents for comparable space.  This projection should be substantiated by an appraiser and/or rent surveys for the property.

When putting together a pro-forma or project statement, the rent for the vacant space is determined by using the market rent for each unoccupied space.  You will use the contract rent for the occupied space.  If your contract rent is lower than market rents, this could hinder the value of your commercial property.

Effective gross income (EGI) is the anticipated income from the property after taking into account a vacancy factor, collection loss and rental collections.  Net operating income (NOI) is the anticipated net income remaining after all operating expenses are deducted from the EGI, not including debt service, depreciation and any income tax concessions.  The NOI is an important number, and you should feel comfortable calculating this.

To calculate the NOI, you need to determine the total operating expenses (OE).  There are all of the expenses and replacement allowances from an operating expense estimate.  Again, you do not include the mortgage debt service in these operating expenses.  Typically, you have fixed expenses and variable expenses to take into account to find the total operating expenses.

Fixed expenses are operating expenses that to not vary regardless of occupancy.  Real estate taxes and insurance are examples of fixed expenses.  Variable expenses are expenses that vary depending on the occupancy.  These expenses can vary from year to year, and include management fees, leasing fees, utilities, payroll, cleaning, maintenance, repair and security, to name a few.  Many times, a replacement reserve is also included in your operating expenses.

Once you have your NOI calculated, you can then look at the debt service of the new loan.  This is easily calculated based on the rate and term being offered.  By subtracting the debt service from the NOI, you come up with a number that is called the pretax cash flow (PTCF).  Divide this by 12, and you have the monthly pretax cash flow of the property.

One final calculation that you will want to be familiar with is the Debt Coverage Ratio (DCR).  Typically most banks want this to be at least 1.15-1.25.  The lower the DCR, the higher the risk of the loan.  To find the DCR, take the NOI and divide it by the annual debt service (ADS).  ADS is basically your loan payments for 12 months.  A DCR of 1.25 means that the income of the property is 25% more than the debt service.  This makes the loan less risky in case the income varies.  With a 1.25 DCR, your income can vary, and you can still make your mortgage payments since there is a cushion there already.

Check back in, I will be looking at commercial lending in more detail in the coming weeks.  If you have commercial lending needs, I am always here to help, please email me or call 877 462 3422 today to discuss your scenario.