In a previous blog post, I talked about a basic back-of-the napkin approach to valuation based on the mantra of a wise and rich client, “If the deal can’t be written on the back of a napkin it’s too complicated”.
In that post I talked about some terms such as cash on cash return (COC) and net operating income (NOI), two very important items in real estate valuation, which I would like to expand upon.
If you recall, I said the first thing I do when evaluating a potential property is this back-of-the-napkin calculation solving for current cash-on-cash (COC) return using my trusty HP12C calculator. The COC return would be the same as the yield or Capitalization Rate (Cap Rate) if the investment were unlevered (i.e., there is no debt or mortgage on the property). Said another way, if the property were purchased for all cash, the Cap Rate and COC return would be the same because it’s an all cash purchase, right?
The NOI divided by the cap rate will yield the value. For instance, if we have an NOI of $100,000 and we divide that by a Cap Rate of 10% (or .10) that would produce a value for the property of what?...........If you said $1,000,000, then you are CORRECT!
The NOI and all of the expenses and income are considered above the line (of the NOI). If there were no reserves required by the lender such as taxes, capital expenditures or tenant improvements then the COC would be based on the NOI less the debt service.
When is the COC not the COC? When these reserves (also called below the NOI line) are required by the lender that further decrease the NOI before debt service. The good news is that some of these reserves may come back in the form of distributions to the partners at a future date if they are not needed to be invested in the property.