Three Strikes and You’re Out - The Real Estate Investment Version
A critical component of any real estate analysis is the net operating income (NOI). NOI is one-half of the equation for computing the capitalization rate. Additionally, it tells you how much money is available to pay debt service. NOI is obtained by subtracting operating expenses from income collected. An accurate NOI should:
* discount guaranteed incomes.
* identify and compute differences between lease collections and market rates.
* identify and amortize potential leasing commissions.
* identify and amortize near-term lessee improvements.
* identify and amortize concessions.
* not include depreciation, acquisition fees, nonrecurring legal and accounting fees, and organization costs.
* show income and expenses with current, real numbers.
NDSC exists when the NOI is less than the cost of debt service. The result is that additional funds have to be provided to pay debt service. All reasonable lenders will agree that the NOI has to be more than the cost of debt service. All reasonable lenders will agree that a NOI which is less than the cost of debt service is unacceptable. The only debate that exists between lenders is how much debt service coverage is needed. Ranges have been between 105% to 135% of NOI as a relationship to debt service costs. The average of 120% is the figure most reasonable lenders favor.
When NDSC does exist, there are five sources for securing additional funds to pay the debt service. They are:
1. A reserve account for debt service shortfall. This account is a disguise for increasing the cost of a failing business.
2. A general reserve account. This account takes funds that otherwise might be needed for repairs and maintenance, marketing, capital improvements, etc.
3. New money from the original investors. Investing additional funds into a failing business is usually not a sound investment practice.
4. New equity money from outside investors. This dilutes the original investor’s position.
5. Placing a junior loan on the real estate, assuming it is allowed by the primary lender. Since the junior loan has been negotiated from a position of weakness, it will have an above market rate and short-term balloon payments. This places an additional burden on the already failing real estate investment.
