Underwriting Standards, Actual vs. Stabilized NOI, and Breakeven Analysis
Q: Can you go over the parameters of analytical and descriptive statements in your opinion? How do you assess statements as they are presented in a package? What is your point of view in general as you review statements?
A: First, it is important to recognize that both descriptive and analytical statements are important components of any analytical write-up. The descriptive statement provides facts without assessment. The analytical statement provides the relevance or importance of the facts in the descriptive statement. It is absolutely critical the appropriate facts are stated in a write up - as the first necessary step - and then that the relevance or importance of those facts are clearly stated by answering the "so what?" question.
Our focus in these sessions is to alert participants to the distinction between a descriptive statement and an analytical statement. In addition, we stress how important it is to avoid providing only facts without an associated analysis of those facts. Facts only become elevator analysis. The reader is told that key performance measures improve or deteriorate but is not informed about the significance of the movement in the performance ratio to a) the borrowing cause, b) the cash sources or repayment, c) the risks to a cash source of repayment, or d) the mitigants to the risk or risks.
Q: Could you please explain the difference between debt constant and the multiplier? Thank you.
A: The debt constant is a unique number for every combination of a) the interest rate, b) the amortization period, c) and the payment frequency. Once identified, a lender can use it to determine the annual debt service for a proposed amount of debt. If the debt constant is for equal quarterly payments, the annual debt service is divided by four to get the amount of equal quarterly debt service. If the constant is for equal monthly payments, the annual debt service is divided by 12 to get the amount of equal monthly payments.
In our initial example, we used the debt constant for an interest rate of 6.00% with a 25-year amortization period, and equal monthly payments, which is 0.077316. To determine the annual debt service with this pricing for a term loan of $4,181,250, we multiply the term loan amount by the debt constant to get annual debt service of $323,278 and monthly debt service of $26,940.
We then illustrated how lenders can use the debt constant to determine how much debt a given amount of net operating income (NOI) can support. To compute this amount, we divide the available NOI by the debt constant.
Q: On Break Even Vacancy why do we have to do 1.00 minus a value? Basically, why do we have to deduct the fraction from the 1.00? What does that 1 represent? Thank you
A: In effect, we first determine what percentage of potential gross income is absorbed by the sum of operating expenses and debt service. We then subtract this percentage amount from 1.00 to estimate the percentage of potential gross income that could be lost before the sum of operating expenses and debt service just match potential gross income. In this instance, potential gross income could fall by 6.8% before operating expenses and debt service were just covered by gross potential income - not much wiggle room if market conditions turn adverse.
Another approach to get at the same issue is to measure the sum of operating expenses and debt service against potential gross income. Using the same example, we see that potential gross income exceeds the sum of operating expenses and debt service by $35,825. This latter amount represents revenue from just two apartments, so if the property lost two tenants, it would be roughly at break-even.
Course overview: Underwriting Standards, Actual vs. Stabilized NOI, and Breakeven Analysis