What You Should Know About Equity Waterfall Models in Commercial Real Estate

Equity waterfall models in commercial real estate projects are one of the most difficult concepts to understand in all of real estate finance. Cash flow from a development or investment project can be split in a countless number of ways, which is part of the reason why real estate waterfall models can be so confusing. In this article we’ll take a deep dive into real estate waterfall distributions, dispel some common misconceptions, and then we’ll tie it all together with a step-by-step real estate waterfall example.

What are Investment Waterfall Distributions?

First of all, what exactly is a “waterfall” when it comes to cash flow distributions? An investment waterfall is a method of splitting profits among partners in a transaction that allows for profits to follow an uneven distribution. The waterfall structure can be thought of as a series of pools that fill up with cash flow and then once full, spill over all excess cash flow into additional pools.

This type of arrangement is beneficial because it allows equity investors to reward the operating partner with an extra, disproportionate share of returns. This extra share of returns is called the promote, which is used as a bonus to motivate the operating partner to exceed return expectations. Under a waterfall structure the operating partner will receive a higher share of profits if the project’s return is higher than expected, and a lower share of profits if the project’s return is lower than expected.

The Importance Of The Owner’s Agreement

With investment waterfalls, cash flows are distributed according to the owner’s agreement. Because there are so many variables when it comes to investment waterfall structures, it’s critically important to always read the owner’s agreement. The agreement will spell out in detail how profits will be split among partners. While there are some commonly used terms and components in investment waterfall structures, waterfall structures can and do vary widely. This means there is unfortunately no one size fits all solution and the only way to understand a specific waterfall structure is to read the agreement.

Common Real Estate Waterfall Model Components

Although waterfall structures vary widely, there are several commonly used waterfall model components. Before we dive into our step-by-step waterfall model example, let’s first take a look at some basic building blocks.

The Return Hurdle

The return hurdle is simply the rate return that must be achieved before moving on to the next hurdle. This is important to clearly define because the return hurdles (or tiers) are what trigger the disproportionate profit splits. Since the term “rate of return” can be defined many different ways, the return hurdle in a waterfall distribution structure can also be defined in many different ways. In practice, the the Internal Rate of Return (IRR) or the Equity Multiple are commonly used as return hurdles. The IRR is the percentage rate earned on each dollar invested for each period it is invested. The Equity Multiple is simply the sum of all equity invested plus all profits divided by the total equity invested, or [(Total Equity + Total Profits) / Total Equity].

Once the return hurdle has been defined the next logical question is, from what perspective will the return be measured? Since a project will have a sponsor and at least one other investor, the return can be calculated from several different perspectives. The return hurdle could be measured from the perspective of the project itself (which could include both the sponsor and the investor equity), the third-party investor equity only, or the sponsor equity only.

The Preferred Return

Another common component in equity waterfall models is the preferred return. What exactly is the preferred return? The preferred return, often just called the “pref”, is defined as a first claim on profits until a target return has been achieved. In other words, preferred investors in a project are first in line and will earn the preferred return before any other investors receive a distribution of profit.  Once this “preference” return hurdle has been met, then any excess profits are split as agreed.

A few key questions with the preferred return are:

  • Who gets the preferred return? Preferred investors could include all equity investors or only select equity investors.
  • Is the preferred return cumulative? This becomes relevant if there isn’t enough cash flow to pay out the preferred return in any given year. In waterfall models this preferred return can either be cumulative or non-cumulative. If the pref is cumulative then it will be added to the investment balance for the next period and accumulate until it’s eventually paid out.
  • Is the preferred return compounded? A preferred return can also be compounded or non-compounded. When the pref is cumulative a key question is, is this unpaid cash flow compounded at the preferred rate of return as it accumulates?
  • What is the compounding period? If the pref is compounded then it’s also important to know the compounding frequency. The compounding frequency could be annually, quarterly, monthly, daily, or even continuous.

The Lookback Provision

The lookback provision provides that the sponsor and investor “look back” at the end of the deal and if the investor doesn’t achieve a pre-determined rate of return, then the sponsor will be required to give up a portion of its already distributed profits in order to provide the investor with the pre-determined return.

The Catch Up Provision

The catch up provision provides that the investor gets 100% of all profit distributions until a pre-determined rate of return has been achieved. Then, after the investor achieves the required return, 100% of profits will go to the sponsor until the sponsor is “caught up.”

The catch up provision is essentially a variation on the lookback provision and seeks to achieve the same goal. The key difference is that with the lookback provision the investor has to go back to the sponsor at the end of the deal and ask the sponsor to write a check. With the catch up provision, the investor gets 100% of all profits until the required return is achieved and only then will the sponsor receive a distribution. Typically the sponsor prefers the lookback provision (since they get to utilize money even if they have to eventually give it back), while the investor prefers the catch up provision (since they get paid first and won’t have to ask the sponsor to make them whole at the end of the deal).

Again, the important thing to remember about waterfall structures is that there is no one sized fits all solution and these terms and conditions will all be spelled out in the owners agreement. With these basic building blocks in our toolkit, let’s next move on to a detailed, step-by-step example of a real estate waterfall model.

Multi-Tier Real Estate Investment Waterfall Calculation Example

Suppose we have a general partner and an outside investor who contribute a combined total of $1,000,000 into a project. The general partner invests 10%, or $100,000, and the outside investor contributes the remaining 90%, or $900,000. All equity investors (which includes both the general partner and the third party investor) receive a 10% annual preferred return on their invested capital. If distributions in any year fall below the preference level of 10%, then the deficiency will be carried over to the following years and compounded annually at the preferred rate of return. In other words, the pref is both cumulative and compounded.

After the 10% preferred return hurdle has been achieved, then all additional profits up to a 15% IRR will be allocated at a rate of 20% to the general partner and 80% to the equity investors. After a 15% IRR hurdle has been achieved, then all additional profits will be allocated at a rate of 40% to the general partner and 60% to the equity investors. All IRR hurdle calculations will be at the project level.

So, based on the above assumptions, we have a 3 tier waterfall model with all IRR hurdles measured at the project level. The first tier or hurdle is a 10% IRR, the second tier is a 15% IRR, and the 3rd tier is anything above a 15% IRR.

Now, let’s looks how how we actually calculate these waterfall distributions.  First let’s take a look at our project level cash flow before tax and equity contributions over the holding period:

Waterfall Distribution Project Cash Flows

The first line is simply our before tax cash flow calculation from a standard real estate proforma. As you can see, the calculated IRR for the entire project is 21.24%. Intuitively this tells us we will reach the third IRR hurdle since 21.24% is greater than our third waterfall hurdle of 15%. The next few lines show how much equity is contributed to the project by the sponsor and investor and when it is contributed. Since all of the equity for this project is required at the beginning, it is all shown at time period 0.

Here is a summary including percentage allocations of the total equity contributions to the project:

Waterfall Distribution Equity Split

As you can see, the sponsor provides 10% of the equity, or $100,000, and the third-party investor contributes 90% of the equity, or $900,000. Next, let’s take a look at a summary of our promote structure discussed above:

Waterfall Distribution Promote Structure

There are 3 tiers (or hurdles) in this promote structure. Profits are split pari passu up to a 10% IRR. After the 10% IRR is achieved, then profits will be split disproportionately. Profits above a 10% IRR up to a 15% IRR will be split 80% to the third-party investor and 20% to the sponsor. In other words, the sponsor gets an additional 10% of profits in addition to his 10% pro-rata share of profits. This additional 10% is the “promote”. Finally, all profits above a 15% IRR will be split 60% to the third-party investor and 40% to the sponsor. This means the sponsor is getting a 30% promote after the final 15% IRR hurdle is achieved.

So far all of our assumptions are pretty straight forward and easy to understand. We have a 90%/10% equity split between the third-party investor and the sponsor, and then we have a 3 tier promote structure.  Now we need a way to actually calculate the profit splits at each tier.

Real Estate Waterfall Model Tier 1

To calculate the profit splits at tier 1 we have to first determine the cash flows required to achieve a 10% IRR. Then, we’ll allocate these cash flows to the sponsor and the investor based on the agreed upon profit splits at this tier. Finally, we’ll calculate how much remaining cash is available from the project that can flow into the next waterfall tier.

This is where waterfall distribution models get complicated, so let’s take it step by step.

Real Estate Waterfall Model Hurdle

The table above has a lot of information, so as we work through it below remember that all we are doing is calculating what a 10% IRR (Tier 1) looks like. Then, once we figure out what cash flows are needed for a 10% IRR, we simply allocate those cash flows (or available cash flows) between the Sponsor and Investor based on our Tier 1 promote structure. Finally, after netting out our Tier 1 cash flows from our before tax cash flows for the project, we figure out how much cash flow is remaining for Tier 2. With this big picture in mind, let’s walk through each line item in the table above.

Year 0 is the beginning of the project and as you can see our beginning balance is $0. On the next line below, you can see our equity contributions at the beginning of the project total $1,000,000. Next is the Tier 1 Accrual line item. This is simply the amount that is owed to the equity investors based on the 10% IRR. In this case the calculation is just 10% times the beginning balance, which for Year 0 is $0 since there is no beginning balance.

The Accrual Distribution line item is next and this is what actually gets distributed in this tier. This may or may not equal the prior Accrual line item. This accrual distribution calculation takes the lesser of 1) the Beginning Balance, plus Equity Contributions, plus the Tier 1 Accrual line item, or 2) the project’s cash flow before tax. The reason why this is the lesser of these two items is because we are limited by the cash flow available from the project and can’t pay out more than this amount. Conversely, if there is more than enough cash flow from the project to pay out what’s owed to us, then we don’t want to pay out any more than this.

The Ending Balance line item takes the sum of the beginning balance, equity contributions, Tier 1 accrual, and Tier 1 distributions. This is simply taking what we start with (beginning balance), then adding in any new equity contributions, then accounting for the difference between what’s owed to us at this tier (the accrual) and what’s been payed out (the distribution).

In Year 1 we use the ending balance from the prior year (Year 0) as our Year 1 Beginning Balance. Then we simply repeat the process discussed above by calculating our Accrual based on the beginning balance for this period, then we calculate our actual distributions for this period, and finally our Ending Balance for this period. We continue this process for all years in the holding period and once completed we can then move on to splitting up cash flows between the Investor and the Sponsor in this tier.

The cash flow splits are shown on the three line items below the Ending Balance: Investor Cash Flow, Sponsor Equity Cash Flow, and Sponsor Promote Cash Flow. Investor cash flow is the percentage of Tier 1 distributions that flow to the investor and sponsor cash flow is divided into two components. First, the sponsor equity cash flow is the portion of Tier 1 distributions attributed to the sponsor’s pro-rata (10%) equity investment. Second, is the sponsor promote cash flow, which is the bonus cash flow that flows to the sponsor for achieving the IRR hurdle. In Tier 1 there is no promote, which means 90% of the Tier 1 distributions flows to the investor and 10% flows to the sponsor.

Real Estate Waterfall Model Tier 2

Now let’s take a look at the second IRR hurdle and repeat the same process we followed for Tier 1:

Real Estate Waterfall Model Hurdle 2

This table is exactly like the table used above for the first hurdle. The key difference is that this time we are calculating the cash flows required for a 15% IRR and then we are splitting them up between the investor and the sponsor at different rates. When calculating the cash flow splits we are also taking into account any distributions made in Tier 1. Let’s take a look at how this works.

In Year 0 we start off with $0, contribute $1,000,000 in equity, and since our beginning balance is $0 there aren’t any accruals nor any distributions. In Year 1 we start off with the $1,000,000 ending balance from Year 0, and our Year 1 accrual is 15%, which is $150,000. However, the project cash flow before tax is only $90,000, so there is a deficiency of $150,000 minus $90,000, or $60,000. This $60,000 deficiency gets added to our ending balance and carried over to the next year, where this process continues.

Once we’ve followed this process for all years in the holding period, we can then move on to calculate the cash flow splits between the investor and the sponsor. This is the same process we followed for Tier 1, except now the sponsor has a 10% promote. This is an additional 10% allocated to the sponsor above and beyond the sponsor’s 10% pro-rata share. Since we are allocating an additional 10% to the sponsor, this 10% is taken away from the investor’s original 90% allocation, which leaves the investor with 80% of the cash flow in Tier 2.

Besides including the promote in this Tier, the other difference here is that we are also netting out the cash flow taken in Tier 1. Since Tier 1 was calculated based on a 10% IRR, the Tier 2 15% IRR already includes the first 10%. In other words, the cash flow distributed in Tier 2 is only the incremental cash flow above 10% and up to 15%. To account for this we must subtract out any cash flow taken in prior tiers when calculating the cash flow for the current tier. This is why the cash flow is $0 for the first four years in the holding period (all of the cash flow was already distributed in Tier 1).

Real Estate Waterfall Model Tier 3

Finally, let’s take a look at the last hurdle, which is an IRR above 15%:

real estate waterfall model hurdle 3

This is the easiest to calculate since we don’t have to figure out the required cash flow for a particular IRR. Instead we simply take all remaining cash flow and allocate it according to the percentage splits at this tier. In this case the sponsor gets a 30% promote in addition to his original 10% share, which leaves the investor with 60% of the cash flow. Just like in Tier 2, all of the cash flow in years 1 through 4 is distributed in the prior tiers, which is why all the cash flows in Tier 3 are from the sale in Year 5.

Waterfall Model Returns Summary

The last component in our real estate waterfall model is to look at the total cash flows across all tiers for the investor and the sponsor and then finally we’ll calculate some overall return metrics.

real estate waterfall returns

In this table we are simply adding up the cash flows from each tier for both the investor and the sponsor. Then we calculate the overall IRR and equity multiple for both the investor and the sponsor. Recall from our project’s cash flow before tax that our project level IRR was 21.24%. However, based on our promote structure the sponsor earns a disproportionate share of these cash flows resulting in a 36.34% IRR for the sponsor and an 18.91% IRR for the investor. This disproportionate cash flow split is also reflected in the equity multiple, which is 1.98x for the investor and 3.85x for the sponsor.

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Conclusion

In this article we tackled the real estate equity waterfall model, which is perhaps the most complicated topic in real estate financial modelling. The reason why real estate waterfall models are so complex is because there are so many variables that can be changed. We discussed some common components in equity waterfall models and emphasized the importance of reading the owner’s agreement in order to truly understand a waterfall structure. Finally, we walked through a detailed 3 Tier waterfall model example step-by-step.

How to Calculate The Debt Yield Ratio

The debt yield is becoming an increasingly important ratio in commercial real estate lending. Traditionally, lenders have used the loan to value ratio and the debt service coverage ratio to underwrite a commercial real estate loan. Now the debt yield is used by some lenders as an additional underwriting ratio. However, since it’s not widely used by all lenders it’s often misunderstood. In this article we’ll discuss the debt yield in detail and we’ll also walk through some relevant examples.

What is The Debt Yield?

First of all, what exactly is the debt yield? Debt yield is defined as a property’s net operating income divided by the total loan amount. Here’s the formula for debt yield:

debt yield

For example, if a property’s net operating income is $100,000 and the total loan amount is $1,000,000, then the debt yield would simply be $100,000 / $1,000,000, or 10%.

The debt yield equation can also be re-arranged to solve for the Loan Amount:

Debt yield loan amount formula

For example, if a lender’s required debt yield is 10% and a property’s net operating income is $100,000, then the total loan amount using this approach would be $1,000,000.

What The Debt Yield Means

The debt yield provides a measure of risk that is independent of the interest rate, amortization period, and market value. Lower debt yields indicate higher leverage and therefore higher risk. Conversely, higher debt yields indicate lower leverage and therefore lower risk. The debt yield is used to ensure a loan amount isn’t inflated due to low market cap rates, low interest rates, or high amortization periods. The debt yield is also used as a common metric to compare risk relative to other loans.

What’s a good debt yield? As always, this will depend on the property type, current economic conditions, strength of the tenants, strength of the guarantors, etc. However, according to the Comptroller’s Handbook for Commercial Real Estate, a recommended minimum acceptable debt yield is 10%.

Debt Yield vs Loan to Value Ratio

The debt service coverage ratio and the loan to value ratio are the traditional methods used in commercial real estate loan underwriting. However, the problem with using only these two ratios is that they are subject to manipulation. The debt yield on the other hand is a static measure that will not vary based on changing market valuations, interest rates and amortization periods.

The loan to value ratio is the total loan amount divided by the appraised value of the property. In this formula the total loan amount is not subject to variation, but the estimated market value is. This became apparent during the 2008 financial crises when valuations rapidly declined and distressed properties became difficult to value. Since market value is volatile and only an estimate, the loan to value ratio does not always provide an accurate measure of risk for a lender. Consider the following range of market values:

debt yield vs LTV

As you can see, the LTV ratio changes as the estimated market value changes (based on direct capitalization). While an appraisal may indicate a single probable market value, the reality is that the probable market value falls within a range and is also volatile over time. The above range indicates a market cap rate between 4.50% and 5.50%, which produces loan to value ratios between 71% and 86%. With such potential variation, it’s hard to get a static measure of risk for this loan. The debt yield can provide us with this static measure, no matter what the market value is. For the loan above, it’s simply $95,000 / $1,500,000, or 6.33%.

Debt Yield vs Debt Service Coverage Ratio

The debt service coverage ratio is the net operating income divided by annual debt service. While it may appear at that the total debt service is a static input into this formula, the DSCR can in fact also be manipulated. This can be done by simply lowering the interest rate used in the loan calculation and/or by changing the amortization period for the proposed loan. For example, if a requested loan amount doesn’t achieve a required 1.25x DSCR at a 20 year amortization, then a 25 year amortization could be used to increase the DSCR. This also increases the risk of the loan, but is not reflected in the DSCR or LTV. Consider the following:

debt yield vs amortization

As you can see the amortization period greatly affects whether the DSCR requirement can be achieved. Suppose that in order for our loan to be approved, it must achieve a 1.25x DSCR or higher. As you can see from the chart above, this can be accomplished with a 25 year amortization period, but going down to a 20 year amortization breaks the DSCR requirement.

Assuming we go with the 25 year amortization and approve the loan, is this a good bet? Since the debt yield isn’t impacted by the amortization period, it can provide us with an objective measure of risk for this loan with a single metric. In this case the debt yield is simply $90,000 / $1,000,000, or 9.00%. If our internal policy required a minimum 10% debt yield, then this loan would not likely be approved, even though we could achieve the required DSCR by changing the amortization period.

Just like the amortization period, the interest rate can also significantly change the debt service coverage ratio. Consider the following:

debt yield vs interest rate

As shown above, the DSCR at a 7% interest rate is only 1.05x. Assuming the lender was not willing to negotiate on amortization but was willing to negotiate on the interest rate, then the DSCR requirement could be improved by simply lowering the interest rate. At a 5% interest rate the DSCR dramatically improves to 1.24x.

This also works in reverse. In a low interest rate environment, abnormally low rates present future refinance risk if the rates return to a more normalized level at the end of the loan term. For example, suppose a short-term loan was originally approved at 5%, but at the end of a 3 year term rates were now up to 7%. As you can see this could present significant challenges when it comes to refinancing the debt. The debt yield can provide a static measure of risk that is independent of the interest rate. As shown above it’s still 9% for this loan.

Market valuation, amortization period, and interest rates are in part driven by market conditions. So, what happens when the market inflates values and banks begin competing on loan terms such as interest rate and amortization period? The loan request can still make it through underwriting, but will become much riskier if the market reverses course. The debt yield is a measure that doesn’t rely on any of these variables and therefore can provide a standardized measure of risk.

Using Debt Yield To Measure Relative Risk

Suppose we have two different loan requests, and both require a 1.20x DSCR and an 80% LTV. How do we know which one is riskier? Consider the following maximum loan analysis for both loans:

Debt Yield Comparison

As you can see both loans have identical structures with a 1.20x DSCR and an 80% LTV ratio, except the first loan has a lower cap rate and a lower interest rate. With all of the above variables it can be hard to quickly compare the risk between these two loans. However, by using the debt yield we can quickly get an objective measure of risk by only looking at NOI and the loan amount:

Debt Yield Comparison 2

As you can see the first loan has a lower debt yield and is therefore riskier according to this measure. Intuitively this makes sense because both loans have the same exact NOI, except the total loan amount for Loan 1 is $320,000 higher than Loan 2. In other words, for every dollar of loan proceeds, Loan 1 has just 7.6 cents of cash flow versus Loan 2 which has 10.04 cents of cash flow.

This means that there is a larger margin of safety with Loan 2, since it has higher cash flow for the same loan amount. Of course, underwriting and structuring a loan is much deeper than just a single ratio, and there are certainly other factors that the debt yield can’t take into account such as guarantor strength, supply and demand conditions, property condition, strength of tenants, etc. However, the debt yield is a useful ratio to understand and it’s being utilized by lenders more frequently since the financial crash in 2008.

Conclusion

The debt service coverage ratio and the loan to value ratio have traditionally been used (and will continue to be used) to underwrite commercial real estate loans. However, the debt yield can provide an additional measure of credit risk that isn’t dependent on the market value, amortization period, or interest rate. These three factors are critical inputs into the DSCR and LTV ratios but are subject to manipulation and volatility. The debt yield on the other hand uses net operating income and total loan amount, which provides a static measure of credit risk, regardless of the market value, amortization period, or interest rate. In this article we looked at the debt yield calculation, discussed how it compares to the DSCR and the LTV ratios, and finally looked at an example of how the debt yield can provide a relative measure of risk.

How to Calculate The Debt Service Coverage Ratio (DSCR)

The Debt Service Coverage Ratio, usually abbreviated as DSCR or just DCR, is an important concept in real estate finance and commercial lending. It’s critical when underwriting commercial real estate and business loans, as well as tenant financials, and is a key part of determining the maximum loan amount. In this article we’ll take a deep dive into the debt service coverage ratio and walk through several examples along the way.

Debt Service Coverage Ratio Definition

First of all, what exactly is the debt service coverage ratio? The debt service coverage ratio (DSCR) is defined as net operating income divided by total debt service.

DSCR formula definition
For example, suppose Net Operating Income (NOI) is $120,000 per year and total debt service is $100,000 per year. In this case the debt service coverage ratio (DSCR) would simply be $120,000 / $100,000, which equals 1.20. It’s also common to see an “x” after the ratio. In this example it could be shown as “1.20x”, which indicates that NOI covers debt service 1.2 times.

What The DSCR Means

What does the debt service coverage ratio mean? A DSCR greater than 1.0 means there is sufficient cash flow to cover debt service. A DSCR below 1.0 indicates there is not enough cash flow to cover debt service. However, just because a DSCR of 1.0 is sufficient to cover debt service does not mean it’s all that’s required.

Typically a lender will require a debt service coverage ratio higher than 1.0x in order to provide a cushion in case something goes wrong. For example, if a 1.20x debt service coverage ratio was required, then this would create enough of a cushion so that NOI could decline by 16.7% and it would still be able to fully cover all debt service obligations.

What is the minimum or appropriate debt service coverage ratio? Unfortunately there is no one size fits all answer and the required DSCR will vary by bank, loan type, and by property type. However, typical DSCR requirements usually range from 1.20x-1.40x. In general, stronger, stabilized properties will fall on the lower end of this range, while riskier properties with shorter term leases or less credit worthy tenants will fall on the higher end of this range.

DSCR Commercial Real Estate Example

The DSCR is critical when sizing a commercial real estate loan. Let’s take a look at how the debt service coverage ratio is calculated for a commercial property. Suppose we have the following Proforma:

DSCR Proforma

As you can see, our first year’s NOI is $778,200 and total debt service is $633,558. This results in a year 1 debt service coverage ratio of 1.23x ($778,200/$633,558). And this is what the debt service coverage ratio calculation looks like for all years in the holding period:

DSCR calculations

As shown above the DSCR is 1.23x in year 1 and then steadily improves over the holding period to 1.28x in year 5. This is a simple calculation, and it quickly provides insight into how loan payments compare to cash flow for a property. However, sometimes this calculation can get more complex, especially when a lender makes adjustments to NOI, which is a common practice.

Adjustments to NOI When Calculating DSCR

The above example was fairly straightforward. But what happens with there are significant lender adjustments to Net Operating Income? For example, what if the lender decides to include reserves for replacement in the NOI calculation as well as a provision for a management fee? Since the lender is concerned with the ability of cash flow to cover debt service, these are two common adjustments banks will make to NOI.

Reserves are essentially savings for future capital expenditures. These capital expenditures are major repairs or replacements required to maintain the property over the long-term and will impact the ability of a borrower to service debt. Similarly, in the event of foreclosure, a professional management team will need to be paid out of the project’s NOI in order to continue operating the property. While an owner managed property might provide some savings to the owner, the lender will likely not consider these savings in the DSCR calculation.

Other expenses a lender will typically deduct from the NOI calculation include tenant improvement and leasing commissions, which are required to attract tenants and achieve full or market based occupancy.

Consider the following proforma, which is the original proforma we started with above, except with an adjusted NOI to account for all relevant expenses that could impact the property’s ability to service debt:

DSCR adjusted NOI

As you can see in the proforma above, we included reserves for replacement in the NOI calculation as well as a management fee. This reduced our year 1 NOI from $778,200 down to $728,660. What did this do to our year 1 DSCR? Now the debt service coverage ratio is $728,660 / $633,558, or 1.15x. This is much lower than what we calculated above and could reduce the maximum supportable loan amount or potentially kill the loan altogether. Here’s what the new DSCR looks like for all years in the holding period:

debt service coverage ratio calculations

Now when the debt service coverage ratio is calculated it shows a much different picture. As you can see, it’s important to take all of the property’s required expenses into account when calculating the DSCR, and this is also how banks will likely underwrite a commercial real estate loan.

How to Calculate The DSCR for a Business

The debt service coverage ratio is also helpful when analyzing business financial statements. This could come in handy when analyzing tenant financials, when securing a business loan, or when seeking financing for owner occupied commercial real estate.

How does the DSCR work for a business? The general concept of taking cash flow and dividing by debt service is the same. However, instead of looking at NOI for a commercial property, we need to substitute in some other measure of cash flow from the business available to pay debt obligations. But which definition of cash flow should be used? Given the importance of debt service coverage, there is surprisingly no universal definition used among banks and sometimes there is even disagreement within the same bank. This is why it’s important to clarify how cash flow will be calculated.

With that said, typically Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA) or some form of adjusted EBITDA will be used. Common adjustments include adding back an appropriate capital expenditure amount required to replace fixed assets (which would offset the depreciation add back), and also taking into account working capital changes (to cover investments in receivables and inventory).

Let’s take an example of how to calculate the debt service coverage ratio for a business.

DSCR business

As shown above, EBITDA (cash flow) is $825,000 and total debt service is $800,000, which results in a debt service coverage ratio of 1.03x. This is found by dividing EBITDA of $825,000 by total debt service of $800,000. This gives us an indication of the company’s ability to pay its debt obligations.

If this analysis were for a tenant, we might want to subtract out existing lease payments and add in the new proposed lease payments. Or, if this were for an owner occupied commercial real estate loan, we would probably subtract out the existing lease payments and add in the proposed debt service on the new owner occupied real estate loan.

Based on the above 1.03x DSCR, it appears that this company can barely cover its debt service obligations with current cash flow. There could be other ways of calculating cash flow or other items to take into account, but strictly based on the above analysis it’s not likely this loan would be approved. However, sometimes looking at just the business alone doesn’t tell the whole story about cash flow and debt service coverage.

Global Debt Service Coverage (The Global DSCR)

Calculating the debt service coverage ratio like we did above doesn’t always tell the whole story. For example, this could be the case when the owner of a small business takes most of the profit out with an above market salary. In this case looking at both the business and the owner together will paint a more accurate picture of cash flow and also the debt service coverage ratio. Suppose this was the case with the company above. This is what a global cash flow analysis might look like if the owner was taking most of the business income as salary:

 

global DSCR

In the above analysis we included the business owner’s personal income and personal debt service. Assuming the owner was taking an abnormally high salary from the business, this would explain the low debt service coverage ratio when looking at the business alone as in the previous example. In this new global debt service coverage calculation we take this salary into account as cash flow, as well as all personal debt service and living expenses. Digging into how personal cash flow is calculated is beyond the scope of this article, but most of this information can be found just from personal tax returns, the personal financial statement, and the credit report, all of which will be required by a lender when underwriting a loan.

As you can see, this new global DSCR paints a much different picture. Now global income is $1,575,000 and global debt service is $1,100,000, which results in a global DSCR of 1.43x. This is found by simply dividing global income by global debt service ($1,575,000/$1,100,000). More often than not, a global cash flow analysis like this tells the full story for many small businesses.

Conclusion

In this article we discussed the debt service coverage ratio, often abbreviated as just DSCR. The debt service coverage ratio is a critical concept to understand when it comes to underwriting commercial real estate and business loans, analyzing tenant financials, and when seeking financing for owner occupied commercial real estate. We covered the definition of the debt service coverage ratio, what it means, and we also covered several commercial real estate and business examples for calculating the debt service coverage ratio. While the DSCR is a simple calculation it’s often misunderstood and it can be adjusted or modified in various ways. This article walked through the debt service coverage ratio step by step to clarify these calculations.

How to Use The Modified Internal Rate of Return (MIRR)

The Modified Internal Rate of Return, often just called the MIRR, is a powerful and frequently used investment performance indicator. Yet, it’s commonly misunderstood by many finance and commercial real estate professionals. In this post we’ll take a deep dive into the concept of the MIRR. We’ll define the MIRR, look at the logic and intuition behind the MIRR, dispel some common mistakes and misconceptions, and finally we’ll tie it all together with a relevant example.

What is MIRR?

First of all, what is the definition of MIRR? The Modified Internal Rate of Return (MIRR) is a variation of the traditional Internal Rate of Return (IRR) calculation in that it computes IRR with explicit reinvestment rate and finance rate assumptions. The MIRR accounts for the reinvestment of any positive interim cash flows by using a reinvestment rate, and it also accounts for any negative cash flows by using a finance rate (also known as a safe rate).

The reason why these two rates are used is because it allows for any positive cash flows thrown off by an investment over the holding period to be reinvested at the “reinvestment rate”. It also allows any negative cash flows to be discounted back to the present time at the “finance rate” to determine how much needs to be set aside today in order to fund the future cash outflows.

By using this approach, the MIRR boils a set of cash flows down to just two numbers: 1) a single initial investment amount at the present time and 2) a total accumulated capital amount at the end of the holding period. Then, a single rate of return can be calculated using only these two numbers, which results in what’s known as the MIRR.

MIRR Example

Let’s take an example of the modified internal rate of return to see how this works. Suppose we have the following set of cash flows:

MIRR Example Cash Flows

We invest $100,000 today and in return we receive $18,000 per year for 5 years, plus at the end of year 5 we sell the asset and get back $100,000. If we use the traditional Internal Rate of Return (IRR) calculation, we get an IRR of 18%.

As you may recall, one of the problems with the traditional IRR calculation is that it doesn’t account for the reinvestment of interim cash flows. So, how can we use the Modified Internal Rate of Return to eliminate this problem?

First, let’s explicitly define a reinvestment rate for all of the $18,000 interim cash flows. In order to account for the yield we can earn on these interim cash flows, let’s assume we can reinvest them at a rate of 10%. Note that this rate is lower than the above calculated IRR. This could be for a variety of reasons. For example, it could be the case that we can’t find any other investments that yield higher than 10%.

MIRR Reinvestment Rate

As shown above, we simply take each of our interim cash flows of $18,000 and then compound them forward at a rate of 10% to the end of year 5. When we add up all of our cash flows at the end of year 5 we get a total of $209,892. By doing this we have transformed our initial set of cash flows into a different time value of money problem, which takes into account the yield we earn on interim cash flows that are reinvested elsewhere. Now we can simply take our new set of cash flows and solve for the IRR, which in this case is actually the MIRR since it’s based on our modified set of cash flows.

MIRR_example_calculation

As you can see, the MIRR when using a 10% reinvestment rate is 15.98%. This is less than the 18% IRR we initially calculated above. Intuitively, it’s lower than our original IRR because we are reinvesting the interim cash flows at a rate lower than 18%. Also take note again that the MIRR calculation here is simply the IRR calculation. The only difference is that now we’ve transformed our initial set of cash flows into a new, modified, set of cash flows. That means that when we now calculate the IRR it’s a modified IRR.

MIRR Example With Negative Cash Flows

Using the reinvestment rate on positive interim cash flows like we did above is how MIRR is commonly used, but sometimes there is more than one negative cash outflow during the holding period. Consider the following set of cash flows:

modified internal rate of return cash flows

We have the same initial $100,000 upfront investment, but now we also have to come out of pocket $50,000 in year 2 for a capital expenditure. However, once this improvement is realized, our cash flows increases from $18,000 to $25,000 and now we can also sell the property at the end of year 5 for a higher price. This results in a higher IRR of 19.33%, but what does it do to our MIRR?

Let’s first tackle the positive interim cash flows by compounding them forward to the end of year 5.

Modified Internal Rate of Return Reinvestment Rate

This is the same process we followed in our first MIRR example, but now we simply ignore the negative cash outflow in year 2. This leaves us with a -$100,000 initial investment, a -$50,000 cash outflow in year 2, and a $309,104 cash inflow at the end of year 5. Next, let’s discount our -$50,000 outflow back to the present time at our finance rate or safe rate.

MIRR finance rate safe rate

This simply tells us that if we want to have $50,000 available to spend in 2 years, then we need to set aside $45,351 today in an account earning 5% annually. So, now we’ve transformed our original set of cash flows into a new modified set of cash flows that has just two figures: a $145,351 initial investment and a $309,104 accumulated capital amount at the end of the holding period.

MIRR calculation 2

Now we can simply calculate an IRR on the above modified set of cash flows to get a Modified Internal Rate of Return of 16.29%. This modified internal rate of return now accounts for the funds we need to set aside today at a safe rate in order to fund future capital outlays. It also accounts for the reinvestment of all interim cash flows at our expected reinvestment rate.

How MIRR Solves the Multiple IRR Problem

You may recall that one of the problems with the traditional IRR calculation is that there are as many solutions to IRR as there are sign changes in a set of cash flows. Let’s take a look at an example set of cash flows:

Multiple IRR Example

When you run an IRR calculation on the above set of cash flows you indeed get multiple solutions. For the above set of cash flows we get 3 different IRR solutions: 0%, 100%, and 200%. So, which one is correct? The answer is that all of them are correct! Why is this? The short answer is that the IRR formula is not a linear equation but instead it’s a polynomial which can generate multiple solutions. This is also the reason why the IRR function in Excel asks for a “guess” as an input. This is used to help Excel determine which solution is correct in case there are multiple solutions.

The good news is that the MIRR eliminates this well-known problem with IRR. To see how, let’s run the MIRR on the above set of cash flows using the same procedure we followed above. We’ll skip the interim steps of discounting negative cash flows at the safe rate and compounding interim positive cash flows at the reinvestment rate. However, this process is exactly the same as we followed above and it leaves us with the following modified set of cash flows:

multiple IRR MIRR solution

And now when we calculate an IRR on this modified set of cash flows we get 2.30%. Using the modified internal rate of return eliminates the multiple IRR problem because we are explicitly defining our safe rate and reinvestment rate. This boils the set of cash flows down to just two figures, resulting in a single MIRR figure.

Conclusion

In this article we discussed the logic and intuition behind the modified internal rate of return, or simply the MIRR. The MIRR is a powerful investment metric that is gaining in popularity since it eliminates the problems with the traditional IRR calculation and also provides a more realistic measure of return. In this article we broke down the MIRR calculation step by step to make understanding the mechanics of MIRR easy to understand.

What is NPV and How Does It Work?

The Net Present Value, abbreviated simply as NPV, is one of the most important concepts in finance and commercial real estate. Compared to the Internal Rate of Return, the concept of NPV is easy to understand, yet it’s also still commonly misunderstood by many commercial real estate and finance professionals. In this article we’ll discuss the concept NPV in depth and leave you with a solid understanding of the logic and intuition behind the Net Present Value.

What Is NPV?

First of all, what exactly is NPV? Net present value (NPV) is defined as an investment measure that tells an investor whether the investment is achieving a target yield at a given initial investment. NPV also quantifies the adjustment to the initial investment needed to achieve the target yield assuming everything else remains the same. Formally, the net present value is simply the summation of cash flows (C) for each period (n) in the holding period (N), discounted at the investor’s required rate of return (r):

npv_formula

 

If all of this math scares you don’t worry, we’ll walk through some detailed examples next that will leave you with a solid intuition and understanding of NPV.

NPV Intuition

What’s the intuition behind NPV? Here’s a simple way to think about the net present value:

 

NPV = Present Value – Cost

 

The net present value is simply the present value of all future cash flows, discounted back to the present time at the appropriate discount rate, less the cost to acquire those cash flows. In other words NPV is simply value minus cost.

What’s does NPV mean? When NPV is viewed as value minus cost, then it’s easy to see that the NPV tells you whether or not what you are buying is worth more or less than what you’re paying.

There are only 3 possible categories NPV will fall into:

  • Positive NPV. If NPV is positive then it means you’re paying less than what the asset is worth.
  • Negative NPV. If NPV is negative then it means that you’re paying more than what the asset is worth.
  • Zero NPV. If NPV is zero then it means you’re paying exactly what the asset is worth.

NPV Examples

Let’s take a look at a few examples to see exactly how to calculate and interpret the net present value or the NPV. First of all, let’s take a look at a sample set of cash flows:

What is NPV Cash Flows

The above set of cash flows shows an upfront investment of -$100,000 (this is a negative number because it’s money leaving our pocket) that returns $10,000 at the end of each year for 5 years, and then at the end of year 5 the original $100,000 investment is also returned. As shown, when an internal rate of return or IRR is calculated on this set of cash flows, we get 10%. That means that the percentage rate earned on each dollar invested for each period it is invested is exactly 10%. So, what about the NPV, the other commonly used discounted cash flow measure?

What is NPV

As shown in the diagram above, when we calculate an NPV on this set of cash flows at an 8% discount rate, we end up with a positive NPV of $7,985. As clearly demostrated above, NPV is calculated by discounting each of the cash flows back to the present time at the 8% discount rate. Then, each of these present values are added up and netted against the initial investment of $100,000 in order to find the net present value. This is exactly how NPV is calculated, step by step.

Let’s take another example of calculating NPV using the same set of cash flows, except with a different discount rate.

negative NPV

In this second example the same exact process is followed in order to calculate the net present value. However, this time we are using a 12% discount rate instead of an 8% discount rate. As shown above, each future cash flow is discounted back to the present time at a 12% discount rate. Then each of these present values are added up and netted against the original investment amount of $100,000, resulting in an NPV of -$7,210.

Notice that when the discount rate is lower than the internal rate of return, our NPV is positive (as shown in the first example above). Conversely, when the discount rate is higher than the IRR, the resulting net present value is negative (as shown in the second example above). Intuitively this makes sense if you think about the discount rate as your required rate of return. The IRR tells us what “return” we get based on a certain set of cash flows. If our required rate of return (discount rate) is higher than the IRR, then that means we want to earn more on the set of cash flows that we actually earn (the IRR). So, in order for us to earn more on a given set of cash flows we have to pay less to acquire those cash flows. How much less? Exactly the amount of the net present value.

Let’s take a final example to see what happens when the discount rate is exactly equal to the IRR:

what is zero NPV

As shown above, when the discount rate is exactly equal to the IRR, then the resulting NPV is exactly equal to zero. Why is this? Well, intuitively if you think about the IRR as the actual return you get from a given set of cash flows, and the discount rate as what you want the return to be from the same set of cash flows, then when these are both equal, NPV will be zero. This means what you want to earn on an investment (discount rate) is exactly equal to what the investment’s cash flows actually yield (IRR), and therefore value is equal to cost.

NPV and The Discount Rate

In order to fully understand how to calculate the net present value you’ll first need a solid understanding of the time value of money. Assuming you’re comfortable with the time value of money and specifically with calculating present values, then you’ll be quick to recognize that the discount rate used has a big impact on determining the present value of future cash flows.

So, what discount rate should you use when calculating the net present value? One easy way to think about the discount rate is that it’s simply the required rate of return that you want to achieve. The discount rate is what you want, the IRR is what you get, and the NPV quantifies the difference. Check out our article on the discount rate for a much more in depth look at this concept.

Conclusion

What is NPV? In this article we discussed what NPV is, detailed how it’s calculated as well as the intuition behind what it means. We also covered some common misconceptions and mistakes and finally we tied it all together with some relevant examples. Once you look at how NPV works, step-by-step, it’s easy to see that NPV is simply value minus cost.

How To Use an HP 10BII Financial Calculator

In finance and commercial real estate it’s simply expected that you know how to use a financial calculator. Yet, it’s surprising how many commercial real estate and finance professionals still don’t know how to properly use a financial calculator. Sometimes it’s because they didn’t learn it correctly the first time, and other times it’s because they simply forgot how to use a financial calculator to perform a less frequently used calculation. It’s also common for people to get stuck with basic but confusing settings such as the payments per year setting.

In this article we’ll solve all of these problems by taking a deep dive into how to use a financial calculator. We’ll discuss everything you need to know about getting started, we’ll cover some routine calculations, and we’ll also tackle some common mistakes and misconceptions.

What’s The Best Financial Calculator to Use?

If you’re just getting started, the first choice you’ll need to make is which financial calculator to actually use. Here are the most popular financial calculators used in commercial real estate and finance today:

  • HP 10BII. This is one of the newer Hewlett Packard models and is widely used in business schools as well as in the finance industry. HP also produces the HP 10BII+ which includes some minor improvements and some more advanced functionality such as probability distribution calculations. The colors are also slightly different. However, the layout and the core calculations for math and the time value of money are the same and everything covered in this article will also apply to the HP 10BII+.
  • TI BA2 Plus. This is one of the newer and most popular Texas Instrument financial calculators and is also widely used in business schools and the finance industry.
  • HP 12C. This is one of the older Hewlett Packard financial calculators. It’s not used much in business schools today but it’s still has a strong following among seasoned veterans. Usually the people wielding this small machine have been running financial calculations longer than most of us young(er) professionals have been alive.

Other financial calculators include the HP17BII, the HP19BII, and the HP20b. These financial calculators are not widely used in finance and commercial real estate and therefore are not recommended.

If you’re just starting out it’s really a toss up between the HP 10BII and the TI BA2 Plus. In a survey of the PropertyMetrics audience the HP 10BII was the most popular financial calculator used, so for the purposes of this article we’ll be focusing on the HP 10BII. If you’d like us to cover another model in a future article, let us know in the comments.

As an aside, both the HP 10BII and the TI BA2 Plus have excellent emulator apps for iOS and Android devices.

Why You Need to First Master The Time Value of Money

Before diving into how to use a financial calculator, you must first master the time value of money. The time value of money is a fundamental building block in finance and commercial real estate. A financial calculator is simply a tool that facilitates time value of money calculations. So, before learning how to use a financial calculator, it’s critical to first master the logic and intuition behind the time value of money.

Time value of money is the economic principle that a dollar received today has greater value than a dollar received in the future.  What’s the intuition behind this principle? Why does money have time value? What are the components of all time value of money problems? These are all great questions and unfortunately outside of the scope of this article. For a more in depth look at the logic and intuition behind the time value of money, check out What You Should Know About The Time Value of Money.

How the HP 10BII Financial Calculator is Organized

Assuming you’re comfortable with the time value of money, let’s next get familiar with the layout of the HP 10BII financial calculator.

Basic Math Functions

The most frequently used buttons will certainly be the math keys. These math keys work just like they do on a regular non-financial calculator. All of the other fancy-looking keys might make things confusing at first, but these math functions should make you feel right at home. As you can see these are easy to find and we have clearly labelled this section in red below.

How to use a financial calculator - math functions

Math functions on the HP 10BII.

Time Value of Money Functions

The time value of money keys are located along the top of the calculator and correspond to the 5 components of all time value of money problems (N, I, PV, PMT, and FV). We’ll cover how to use these keys in more detail below, but here’s where these keys are located on the HP 10BII:

How to use a financial calculator - time value of money keys

Time value of money functions on the HP 10BII.

Gold and Purple Keys

You probably already noticed the solid purple and gold keys. These frequently used keys are needed to shift through different functions for the same key. If you look closely at the other keys on the financial calculator you’ll notice that they have white letters, gold letters, and purple letters.

The white letters are the primary functions, while the gold and purple letters indicate alternative functions for the same key. You can use any of these alternate functions at any time by simply pressing the appropriate shift key (gold key for example) and then pressing the function key with the gold label that you want to use. We’ll demonstrate this process below, but here’s where these keys are located in case they didn’t already stand out to you:

How to use a financial calculator gold purple keys

Gold and purple keys on the HP 10BII

How to Use Basic Functions and Settings

Now that we have a general feel for how the financial calculator is organized, let’s go over some frequently used functions and useful settings you should understand.

How to Turn Your Financial Calculator On and Off

Turning the HP 10BII on and off is pretty simple. All you have to do is use the ON Button to turn it on or the Gold Key first then the ON button to turn it off. Notice the gold text on the ON button, which indicates this is a secondary function for the same button that needs to be preceded by the Gold key.

How to turn your financial calculator on and off

How to turn the HP 10BII on

How to turn HP 10BII on and off

How to turn the HP 10BII off

How to Clear All Registers

As you work through different problems on your financial calculator, one of the easiest ways to make a mistake is to not clear out your existing work from other problems. The clear all function will immediately clear out all of your prior work so you can start a new problem with a clean slate. To accomplish this all you need to do is simply press the Gold key followed by the C key.

How to clear all work on the HP 10BII

How to clear all work

How to Use The Plus and Minus (+ / – ) Sign Key

A common task when using a financial calculator, especially when working with the time value of money functions, is changing the sign of a number. The HP 10BII makes this easy with a dedicated plus and minus ( + / – ) sign key, which toggles the sign of an inputted number. To change the sign of a number on the HP 10BII, simply input or calculate a number, then hit the +/- key as shown below:

HP 10BII change sign

HP 10BII change sign

How to Use The Memory Register

There are a couple of different ways to store and recall numbers on the HP 10BII. First, we’ll go over the memory register key, which just stores one value at a time. To use the M register, simply input or calculate a number, then hit the M register key as show below. To recall a value stored on the M register, simply press the RM or recall memory key:

M register key HP 10BII

How to store value in the memory register

HP 10BII recall memory

How to recall value from the memory register

How to Store and Recall Multiple Values From Memory

If you want to store multiple values then you’ll need to use a different approach. This is particularly useful when you are calculating multiple figures that then later need to be used in a final calculation. To do this you’ll need to use the store and recall key as shown below:

HP 10BII store and recall key

Store and recall key on the HP 10BII

To store a number using this approach, use the following procedure:

  1. Input or calculate a number
  2. Press the gold key
  3. Press the STO key
  4. Press a number (0-9) where you’d like to store the value

This is a straightforward process on the HP 10BII but it does involve a lot of steps that can be cumbersome and sometimes annoying. This is one area where the TI BA2 Plus offers a much faster and simpler solution since the store and recall keys are two separate buttons (no extra shift key is required). The TI BA2 Plus is outside of the scope of this article, but if you’ll be storing and recalling multiple numbers like this on a regular basis, then you’ll probably like the TI BA2 Plus better.

Recalling a stored value is a lot easier:

  1. Press the RCL button
  2. Press a number (0-9) where you previously stored a value

 

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Step by step instructions and examples for using an HP 10BII financial calculator. This course is currently closed. Signup below to join the waitlist.

 

How to Use The Time Value of Money Keys

Now that we have a good understanding of how the HP 10BII financial calculator is organized and we’ve also gone over some regularly used functionality, let’s dive into the time value of money. This is, after all, what a financial calculator is built for.

Assuming you’re comfortable with the concepts of the time value of money (in particular the 5 components of all time value of money problems), the time value of money keys on the 10BII are very intuitive to use. The best way to master using the time value of money keys on the 10BII is to simply practice. Below we’ll go over how to use each of the 5 keys individually and also go over some practice problems. But first, lets discuss how to avoid a common mistake people make when using a financial calculator.

Consistency of The Time Value of Money Components

One of the most common problems people make when using a financial calculator is inputting inconsistent time value of money components. When solving for time value of money problems it’s critical that the frequency of the N, I, and PMT components match. For example, if the number of periods (N) in the problem is monthly, then the interest rate (I) and payments per period (PMT) must also be expressed monthly.

The HP 10BII financial calculator has a built in settings for payments per year that attempts to auto-adjust the interest rate based on how many periods there are in a year. However, this does not auto-adjust the N and PMT components (you still have to do this manually), which makes this function cause more problems than it’s worth. For this reason it’s better to set payments per year to 1 and then totally ignore this setting. You’ll need manually adjust the components in each problem so that they match in frequency, but this will result in fewer errors. You can set the payments per year setting to 1 by simply pressing the 1 key, then the gold key, and finally the PMT key.

HP 10BII payments per year

HP 10BII payments per year

So, assuming you have your financial calculator set to 1 payment per year and you’ve cleared all registers, let’s go through some example problems to demonstrate how to use the time value of money functions on the HP 10BII financial calculator.

Solve for Present Value on the HP 10BII

Let’s take a look at a present value problem and then solve it with the HP 10BII.

A U.S. savings bond will be worth $10,000 in 10 years. What should you pay for it today in order to earn 6.5% annually?

To solve this time value of money problem let’s take a look at the 4 variables that we know. We are given the future value FV of $10,000, the number of periods N is 10 years, and the rate I is 6.5% per year. There is no payment and both the rate and the number of periods are consistent, so we can now solve for the unknown present value PV, which is $5,327.

To do this on the HP 10BII, first clear all prior work, and then use the following steps:

  1. Input 10,000 and press the FV key
  2. Input 10 and press the N key
  3. Input 6.5% and press the I/YR key
  4. Input 0 and press the PMT key
  5. Press the PV key to solve for the present value
Solve for Future Value on the HP 10BII

What will $100,000 invested today for 7 years grow to be worth if compounded annually at 5% per year?

To solve this problem simply identify the 4 known components and then use the HP 10BII financial calculator to find the 5th unknown component. In this problem we know the present value PV is -$100,000 because it’s what’s invested today. It’s negative because it’s leaving our pocket when we put it into the investment. The number of periods N is 7 years, and the rate I is 5%. The N and I components are both expressed annually, so they are consistent. Knowing this we can simply plug those 4 components into the calculator and solve for future value FV, which is $140,710.

  1. Input -100,000 and press PV
  2. Input 7 and press N
  3. Input 5% and press I/YR
  4. Input 0 and press PMT
  5. Press the FV key to solve for the future value
Solve for Payment on the HP 10BII

What are the monthly payments on a 30 year loan of $300,000 at a annual rate of 4.5% compounded monthly?

In this problem we are given the total number of periods N of 30 years, a present value PV of $300,000, an annual interest rate I of 4.5% compounded monthly, and because this is a loan amortized over 30 years, it is implied that the future value FV is $0. After a quick check it appears that the number of periods and the rate are actually expressed in different compounding periods, which of course presents a conflict. To resolve this let’s adjust the N and I components so they are both expressed monthly. We can convert the total number of compounding periods to 30 x 12, or 360 months and the rate to 4.5% / 12, or 0.375% per month. Now we have our 4 known components and can easily solve for the monthly payment amount, which is $1,520.

  1. Input 300,000 and press PV
  2. Input 360 and press N
  3. Input .375 and press I/YR
  4. Input 0 and press FV
  5. Press the PMT key to solve for the payment
Solve for Interest Rate on the HP 10BII

To solve for the interest rate, let’s take a look at a variation on the present value problem above.

A U.S. savings bond will be worth $10,000 in 10 years. If you paid $5,327 for it today, how much would you earn on an annual basis?

In this problem we know that the present value PV is $5,327 because that is what we are paying for the investment today. The future value FV is $10,000 since this is the lump sum we will receive in the future. Because it isn’t explicitly given, we know that the payment amount is implied to be 0. The number of periods N is given to us as 10 years. So, now we know 4 out of the 5 time value of money components and we can easily solve for the 5th unknown interest rate component, which turns out to be 6.5%

  1. Input -5,327 and press PV
  2. Input 10,000 and press FV
  3. Input 10 and press N
  4. Input 0 and press PMT
  5. Press the I/YR key to solve for the interest rate
Solve for Number of Periods on the HP 10BII

To solve for the number of periods, let’s take another variation of the present value problem above.

If you paid $5,327 for a U.S. Savings Bond today and earned 6.5% annually on your investment, how many years would it take for your investment to be worth $10,000?

In this problem we know that the present value PV is $5,327 because that’s what we are paying for the investment today. The interest rate is 6.5% annually because this is how much we earn each year. Finally, we know that the future value FV is $10,000 because this is how much the investment will be worth at some point in the future as it compounds. How far into the future? Well, now that we know 4 out of the 5 components we can simply plug them in and solve for N, which is 10 years.

  1. Input -5,327 and press PV
  2. Input 10,000 and press FV
  3. Input 6.5% and press I/YR
  4. Input 0 and press PMT
  5. Press N to solve for the number of periods

 Conclusion

In this article we showed you how to use a financial calculator step by step. We specifically focused on the HP 10BII and detailed how the calculator is organized, how to perform common calculations and functions, and finally we covered how to use the time value of money keys along with step by step examples. Additionally, we took a look at some common mistakes people make when learning how to use a financial calculator and we showed you how to avoid making these errors. Learning how to use a financial calculator is not a quick process and it does take time. There are many features of the HP 10BII that we did not cover in this article, but the elements we discussed will give you a solid foundation.

The Difference Between Recourse and Non-Recourse Loans

What’s the difference between a recourse and a non-recourse loan? In commercial real estate both types of loans are common depending on the stage and type of financing. In this short article we’ll take a closer look at commercial real estate loans, and specifically the difference between recourse and non-recourse commercial real estate loans, as well as what’s covered by the “bad boy guaranty.”

The Definition of Recourse and Non-Recourse

First of all, what do the terms recourse and non-recourse mean? The definition of a recourse loan is a loan where the borrower or guarantors are personally liable for repaying any outstanding balance on the loan, in addition to the collateral itself. In other words, if the collateral securing a loan needs to be liquidated but is insufficient to cover the total amount owed on the loan, then “recourse” enables the lender to go after the guarantors personally to cover this deficiency. Full recourse loans are common with construction and other shorter term commercial real estate financing, such as a mini-perm loan that finances lease up and stabilization of an asset.

A non-recourse loan is defined as a loan where the borrower or guarantors are not personally liable for repaying any outstanding balance on the loan. Non-recourse financing is typically found on longer term permanent commercial real estate loans placed on a stabilized and performing asset. However, a common misconception with non-recourse loans is that if a loan is non-recourse then a borrower or guarantor can never be held personally liable in the case of a loan default. This is not always true and there are several exemptions commonly covered under what’s known as carve out provisions or the bad boy guaranty.

The Non-Recourse Loan Bad Boy Guaranty

Carve out provisions, also known as bad boy guaranties, protect the lender and enables personal recourse in the case of certain events, such as fraud. Essentially, bad boy guaranties are exceptions to the non-recourse status of a loan that originally were created to prevent the borrower from siphoning cash out of a property in the months leading up to a loan default. This varies by state, but here are some common carve out provisions of bad boy clauses included in non-recourse loans:

  • Filing for bankruptcy
  • Fraud or misrepresentation
  • Failure to maintain required insurance
  • Failure to pay property taxes
  • Any environmental indemnification
  • Committing a criminal act

Another common misconception with non-recourse loans is that the bad boy guaranty is limited to just these major events or bad acts. In the past this was typically true, but over time, the bad boy guaranty has slowly expanded to include more and more minor provisions, such as failure to deliver financials to the lender or permit lender inspections of the property. These and other minor carve out provisions may or may not be appropriate or acceptable.

As always, it’s critical to read and understand the loan documents and it’s always best to have them reviewed and negotiated by a competent commercial real estate attorney.

Recourse vs Non-Recourse Loan Example

Let’s take an example to illustrate the difference between recourse and non-recourse loans. Suppose a borrower has the following loan outstanding for an office building:

Recourse vs Non Recourse Loan

Now, suppose the vacancy goes up in the building much higher than expected and market based rental rates decline substantially. Unfortunately, the borrower can’t keep up with his loan payments and ends up defaulting on his loan.

With a non-recourse loan the lender can take back the real estate which is collateral for the loan. Sometimes this will be adequate, but what if the liquidation value of the collateral is no longer sufficient to repay the outstanding loan balance?

Let’s further suppose that the higher than expected vacancy and reduced NOI cause the building value to decline to only $3,000,000, which is less than the outstanding loan balance of $4,000,000. In this scenario, the lender does not have any personal recourse to cover the shortfall, so if the building is foreclosed and liquidated then the lender will take a loss.

Now let’s look at what would happen if this was a recourse loan. Assume the guarantor has the following personal financial statement:

Recourse loan personal financial statement

If the above loan was a recourse loan, then the lender would not only be able to liquidate the collateral for $3,000,000, but the lender would also be able to go after the guarantor personally for the deficiency of $1,000,000. This means the bank could levy or legally seize the guarantors bank accounts, wages, and other assets in order to satisfy any outstanding debt.

Conclusion

In this article, we discussed recourse vs non-recourse loans, as well as some common misconceptions and pitfalls to avoid. Recourse just puts the borrower or guarantor on the hook for the loan, in addition to the collateral itself. In construction and mini-perm loans a full personal guarantee from the sponsors is almost always required. This aligns incentives to get a property fully constructed, leased, and stabilized. Longer term loans on stabilized properties are typically non-recourse, unless otherwise triggered by various “bad boy” clauses. This limits the personal exposure for borrowers, but also protects the lender and allows them to go after the borrower/guarantors personally in the case of certain events such as fraud.

What You Should Know About The Triple Net (NNN) Lease

The NNN Lease, often just called the triple net lease, is a common lease structure used in commercial real estate. Despite the popularity of the NNN lease, the triple net lease structure is still commonly misunderstood by many commercial real estate professionals. In this article we’ll take a deep dive into the NNN lease, dispel some common misconceptions about the triple net lease, and then finally we’ll tie it all together with a clear and concise example.

What is a Triple Net (NNN) Lease?

First of all, what exactly is a triple net, or NNN, lease? A triple net (NNN) lease is defined as a lease structure where the tenant is responsible for paying all operating expenses associated with a property. The triple net or NNN lease is considered a “turnkey” investment since the landlord is not responsible for paying any operating expenses. With that said, in order to fully understand the NNN lease you must first understand the spectrum of commercial real estate leases.

The Spectrum of Commercial Real Estate Leases

All commercial real estate leases fall somewhere along a spectrum with absolute net leases on one end and absolute gross leases on the other end. Most leases fall somewhere in the middle and are considered to be a hybrid lease.

Commercial real estate net lease spectrum

When most people talk about a triple net or NNN lease, they are usually thinking about an absolute net lease. However, just because a lease is called or labelled an NNN lease, does not mean it’s actually an absolute net lease. Often a lease will be called a “triple net lease” for convenience when in fact it is not.

For example, when a building is brand new the tenant may indeed be responsible for funding replacements such as the roof or HVAC systems as they wear out over time. However, on older buildings a lease can often be called triple net, but actually require the landlord to fund these capital expenditures over time, rather than the tenant.

The most important thing to remember when working with commercial real estate leases is to ALWAYS read the lease. The only way to truly understand the terms and conditions of a lease is to actually read the lease. Simple labels like triple net, full service, or modified gross, which are commonly used by brokers and landlords, will often conflict with the actual terms of the lease.

What the NNN Lease Does Not Include

Even if your lease is a true absolute net lease, a common misconception is that even a true absolute net lease covers ALL expenses associated with a property, which is not always the case. While a true absolute NNN lease with a strong tenant can be thought of as a turnkey commercial property from the landlord or investor’s perspective, even an absolute net lease has some expenses that won’t be covered by the tenant(s).

For example, it’s rare for an NNN lease to cover the accounting costs charged by the landlords CPA or legal costs charged by the landlord’s attorneys when drafting or reviewing documents. While these costs are usually small relative to the purchase price of a property, they are nonetheless not typically covered in a standard “NNN lease”.

Triple Net Lease Investment Risks

A common misconception with triple net lease investments is that they are almost risk-free. While triple net investments do offer several advantages, there are still several risks that should be taken into consideration. The primary advantages of triple net lease investments are that you get a predictable revenue stream due to the long-term leases and pass-throughs in place, and you also get a relatively hassle-free investment due to the low management requirements.

While these are compelling advantages, triple net leases also do come with several inherent risks. First, because most triple net lease investments are for single-tenant properties, tenant credit risk is important to understand. For example, not many today doubt the strength of a triple net Walgreens investment since the lease is guaranteed by the parent company, which is publicly traded and financially strong. On the other hand, it is very possible for financial strong and publicly traded tenant to fall out of favor over the term of the lease and ultimately go bankrupt. Since single tenant triple net properties are either 0% vacant or 100% vacant, this should be taken into consideration.

Another risk to consider is the risk of re-leasing. A lot of triple net investment properties are sold towards the end of a longer term lease, shifting the risk of re-leasing the property to the new owner. If the new owner does not have this skillset or a strong team to handle this, then this could present considerable tenant rollover risk.

Assessing Tenant Credit Risk in a Triple Net Lease

One important component to take into account when analyzing a triple net lease investment property is understanding the credit risk of the actual tenant(s). After all, a lease is only as strong as the tenant behind it, so analyzing the financial statements of the tenant on the other side of the NNN lease is critical in understanding downside risk.

Many single tenant triple net lease deals involve publicly traded companies such as Starbucks, Walgreens, or Arby’s. In this case it’s easy to pull up credit ratings on the companies bond issues and to also read stock analyst reports.

For private companies credit analysis requires some more effort, but analyzing financial statements and trends to better understand credit risk is a worthwhile endeavor. For these situations, here’s a primer on better understanding tenant credit analysis.

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Triple Net Lease Example

Let’s take an example to see how a proforma is structured with a triple net lease in place. Suppose we have the following cash flows for a sample investment property:

NNN Lease Example No Reimbursements

The above proforma includes no expense reimbursements from the tenant. In other words, the above proforma assumes all of the leases are absolute gross leases, where the landlord pays all of the expenses for the property. Now, let’s take a look at how the proforma changes when the tenant reimburses the landlord for all of the property’s expenses:

NNN Lease Example

As you can see on the second proforma, the triple net lease in place provides additional reimbursement income that cancels out all of the operating expenses. To be fair, a triple net lease rate will typically be significantly lower than an equivalent gross lease rate for the same property, which would make the bottom line cash flows under a gross lease and a net lease much closer together than in the above example.

However, what the NNN lease ultimately achieves is that it shifts the responsibility, and therefore the risk, of paying the operating expenses from the landlord to the tenant. For example, if property taxes increase one particular year at an unusually high rate, then the landlord’s bottom line cash flow will be protected under an NNN lease and the tenant will be the one responsible for bearing this increased expense. The above shows how a proforma would be structured with these reimbursements in place.

Conclusion

The NNN lease, often just called the “triple net lease” is a popular lease structure in commercial real estate. In this article we defined the triple net lease in the context of the overall spectrum of all commercial real estate leases. We also discussed some common misconceptions about the NNN lease, reviewed some of the major risks associated with triple net lease investment properties, and finally we walked through how a triple net lease proforma is structured.

 

How to Use the Operating Expense Ratio

The operating expense ratio provides a lot of useful insight into a commercial property analysis, but it’s not as widely used as it ought to be. The operating expense ratio is a simple ratio that’s easy to calculate and in this article we’ll take a closer look at how to calculate the operating expense ratio, how to interpret it, and finally we’ll tie it all together with a solid example.

Operating Expense Ratio Definition

First of all, what exactly is the operating expense ratio? The operating expense ratio is simply the total of all expenses needed to operate a property divided by the potential rental income for a property. Here’s the operating expense ratio formula:

operating expense ratio

The operating expense ratio formula measures how much of a property’s potential rental income is consumed by expenses needed to operate the property. When building a multi-year proforma, it can often be helpful to calculate an operating expense ratio for each year in the holding period in order to spot trends in total operating expenses, relative to potential rental income.

Operating Expense Ratio Example

Let’s take an example to illustrate how to calculate the operating expense ratio. Suppose we have potential rental income of $100,000 and total operating expenses of $45,000. Here’s how we’d calculate an operating expense ratio for this property:

operating expense ratio example

Now, let’s further suppose that we have a 5 year proforma that looks like this:

Proforma Operating Expense Ratio
By calculating the operating expense ratio for each year in the holding period, we can quickly spot a trend in the total expenses as they relate to potential rental income.

Operating Expense Ratio Calculation

As you can see from the calculations above, the operating expenses for this property increase faster than our potential rental income does, which causes our operating expense ratio to increase over the holding period. By calculating the operating expense ratio for each year in the holding period, we can quickly spot and quantify this trend at a glance.

The Operating Expense Ratio and Vacancy

Sometimes you might also see the operating expense ratio calculated using effective rental income instead of potential rental income. Effective rental income is just potential rental income less any vacancy and credit losses. Here’s how this variation is calculated:

operating_expense_ratio_eri

Why include vacancy in the operating expense ratio? This can be useful when you want to measure how efficiently a property is being managed. Since managing vacancies is part of operating a property efficiently, including this in the operating expense ratio might make sense. For example, if a property is poorly managed then vacancy will likely be higher than it should be, and therefore including vacancy in the operating expense ratio will give an indication of this.

Conclusion

In this short article we covered the operating expense ratio, which is a helpful calculation used in the analysis of commercial real estate. It gives an indication of how much of a property’s income is consumed by operating expenses. When building a multi-year proforma it can also be helpful to calculate the operating expense ratio for each year in the holding period in order to quickly spot and quantify trends in operating expenses relative to income.

What is a Tenant Estoppel and How Does It Work?

In commercial real estate the tenant estoppel often comes up during the due diligence phase of an acquisition or during the underwriting of a loan. What exactly is a tenant estoppel and how does it work? Let’s dive in and take a closer look at the tenant estoppel.

What is a Tenant Estoppel?

What exactly is a tenant estoppel? By definition, an estoppel certificate is a “signed statement by a party certifying for another’s benefit that certain facts are correct, as that a lease exists, that there are no defaults, and that rent is paid to a certain date. A party’s delivery of this statement estops that party from later claiming a different state of facts.’’ Black’s Law Dictionary, 572 (7th Ed., 1999).

In other words a tenant estoppel is a certified statement by a tenant that verifies the terms and conditions and current status of their lease. Most commercial real estate leases require a tenant to provide an estoppel letter or certificate upon request and this is often a critical step during the due diligence phase of an acquisition and the also during the underwriting of a commercial real estate loan.

Why is this so important? The tenant estoppel provides proof of cash flow, which is ultimately what a potential investor or lender in a property is concerned with.

As an aside, the word “estop” simply means to prohibit, and a tenant estoppel is therefore a certificate that prohibits the tenant from taking a position contrary to what is stated in their certificate.

What’s in a Tenant Estoppel Letter or Certificate?

While the actual items required in a tenant estoppel will vary, here are some common points covered in a typical tenant estoppel letter or certificate:

  • The commencement date of the lease.
  • The date to which rent has been paid.
  • That there are no defaults by either the landlord or the tenant.
  • If there are defaults by either party, then a specification of these defaults will be required.
  • Verification that the lease is unmodified and in full force and effect.
  • If the lease has been modified, then the estoppel certificate will include a statement verifying what modifications have been made.

Most leases will have a provision requiring a tenant to provide a tenant estoppel letter or certificate upon request, however, the details of what is to be included in the actual tenant estoppel certificate can vary. The above items are usually a good starting point.

Conclusion

The tenant estoppel is a common item that often comes up during the due diligence phase of an acquisition and during the loan underwriting process. It’s used to provide a third-party insight into the relationship between a landlord and a tenant. In this short article we covered the purpose of the tenant estoppel and the basic items included.

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