CHAPTER 18
Investment Decisions: Ratios
Test Problems
1. Income multipliers:
a. Are useful as a preliminary analysis tool to weed out obviously unacceptable
2. The overall capitalization rate calculated on a potential acquisition:
3. The operating expense ratio:
4. The equity dividend rate:
b. Expresses before-tax cash flow as a percent of the required equity capital
5. Ratio analysis:
d. Serves as an initial evaluation of the adequacy of an investment’s expected cash
6. Assume a retail shopping center can be purchased for $5.5 million. The center’s
first year NOI is expected to be $489,500. A $4,000,000 loan has been requested.
The loan carries a 9.25 percent fixed contract rate, amortized monthly over 25
years with a 7-year term. What will be the property’s (annual) debt coverage ratio
in the first year of operations?
7. Which of the following is not an operating expense associated with
income-producing (commercial) property?
Use the following information to answer questions 8-9.
You are considering purchasing an office building for $2,500,000. You expect the
potential gross income (PGI) in the first year to be $450,000; vacancy and collection
losses to be 9 percent of PGI; and operating expenses and capital expenditures to be 38
percent and 4 percent, respectively, of effective gross income (EGI).
8. What is the implied first-year overall capitalization rate?
9. What is the effective gross income multiplier?
10. Given the following information, what is the required equity down payment?
• Acquisition price: $800,000
• Loan-to-value ratio: 75%
Study Questions
Use the following information to answer questions 1 – 3:
You are considering the purchase of an office building for $1.5 million today. Your
expectations include the following: first-year potential gross income of $340,000;
vacancy and collection losses equal to 15 percent of potential gross income; operating
expenses equal to 40 percent of effective gross income and capital expenditures equal 5
percent of EGI. You expect to sell the property five years after it is purchased. You
estimate that the market value of the property will increase four percent a year after it is
purchased and you expect to incur selling expenses equal to 6 percent of the estimated
future selling price.
1. What is estimated effective gross income (EGI) for the first year of operations?
Solution:
Item Amount
Potential gross income (PGI) $340,000
2. What is estimated net operating income (NOI) for the first year of operations?
Solution:
Item Amount
Effective gross income (EGI) $289,000
less: Operating expenses (OE) (115,600)
3. What is the estimated going-in cap rate (Ro) using NOI for the first year of
operations?
4. An investment opportunity having a market price of $1,000,000 is available. You
could obtain a $750,000, 25-year mortgage loan requiring equal monthly
payments with interest at 7.0 percent. The following operating results are
expected during the first year.
Effective gross income $200,000
Less operating expenses and CAPX $100,000
Net operating income $100,000
For the first year only, determine the:
a. Gross income multiplier
b. Operating expense ratio (including CAPX)
Solution: Operating expenses / Effective gross income = $100,000 / $200,000 =
c. Monthly and annual payment
d. Debt coverage ratio
e. Debt yield ratio
f. Overall capitalization rate
g. Equity dividend rate
Note: Equity investment = Acquisition price – loan amount
5. You are considering the purchase of a quadruplex apartment building. Effective
gross income (EGI) during the first year of operations is expected to be $33,600
($700 per month per unit). First-year operating expenses are expected to be
$13,440 (at 40 percent of EGI). Ignore capital expenditures. The purchase price of
the quadruplex is $200,000. The acquisition will be financed with $60,000 in
equity and a $140,000 standard fixed-rate mortgage. The interest rate on the debt
financing is eight percent and the loan term is 30 years. Assume, for simplicity,
that payments will be made annually and that there are no up-front financing
costs.
a. What is the overall capitalization rate?
Solution: NOI = EGI – operating expenses
b. What is the effective gross income multiplier?
c. What is the equity dividend rate (the before-tax return on equity)?
Solution:
N = 30 I/YR = 8 PV = $140,000 PMT = ? FV = 0
Before-tax cash flow = NOI – Debt service
Equity dividend rate = Before-tax cash flow / equity invested
d. What is the debt coverage ratio?
Solution: DCR= NOI / debt service
e. Assume the lender requires a minimum debt coverage ratio of 1.2. What is the
largest loan that you could obtain if you decide to borrow more than $140,000?
Solution: Debt service must be such that the following relationship holds:
2.1
ServiceDebt
NOI
vacancy and collection losses to be 9 percent of PGI; and operating expenses and
capital expenditures to be 42 percent of effective gross income (EGI). What is the
estimated Net operating income? What is the implied first year overall
capitalization rate? What is the effective gross income multiplier?
Item Amount
Potential gross income (PGI) $450,000
– Vacancy & collection loss (VC) 40,500
– Operating expenses (OE) 171,990
What is the overall capitalization rate?
%5.9095.0
000,500,2$
510,237$
Pr
0or
iceAcqusition
NOI
R
What is the effective gross income multiplier?
10.6
500,409$
000,500,2$
Pr
IncomeGrossEffective
icenAcquisitio
GIM
9. What distinguishes an operating expense from a capital expenditure?
Solution: An operating expense does not fundamentally alter the market value or
remaining economic life of the asset; rather operating expenses simply keep the
property operating and competitive in its local market. In contrast, a capital
expenditure is defined as an expense that does increase the market value and/or
remaining economic life of the asset.
10. Explain why income property cash flow is not the same as taxable income.
Solution: For several reasons, the actual net cash flow generated by a rental
property investment is different than the amount of income the owner must report
for federal income tax purposes. First and foremost, a deduction for depreciation
11. What is the basic shortcoming of most ratios and rules of thumb used in
commercial real estate investment decision making?
Solution: The major weakness of most ratios and rules of thumb is that they
12. Using the following information, compute net operating income ( NOI ) for the
first year of operations. Use an “above-line” treatment of capital expenditures.
• Number of apartments: 10
• Rent per month per apartment: $900.00
• Expected vacancy and collection loss: 10 percent
• Annual maintenance: $18,000
• Property taxes: $9,000
• Property insurance: $7,000
• Management: $8,000
• Capital expenditures: $5,000
• Other operating expenses: $3,000
• Annual mortgage debt payments: $35,000
Solution:
Potential gross income $108,000 (10 x $900 x 12)
– Vacancy and collection
losses
10,800 @ 10 percent of PGI
= Effective gross income 97,200
– Annual maintenance 18,000
– Property insurance 7,000
– Other operating expenses 3,000
= NOI $47,200