You are considering the purchase of an industrial
warehouse. The purchase price is $1 million.
You expect to hold the property for five years.
You have decided to finance the acquisition with
the $700,000 loan, 10 percent interest rate, 30-
year term, and annual interest-only payments.
(That is, the annual payment will not include any
amortization of principal.) There are no up-front
financing costs. You estimate the following cash
flows for the first year of operations:
$135,000 Effective gross income
27,000 Operating expenses
$108,000 NOI
a. Calculate the overall rate of return (or “cap
rate”).
b. Calculate the debt coverage ratio.
c. What is the largest loan that you can obtain
(holding the other terms constant) if the
lender requires a debt service coverage ratio
of at least 1.2?
a. To calculate the overall rate of return or "cap rate", you need to divide the Net Operating Income (NOI) by the purchase price.
Overall Rate of Return = NOI / Purchase Price
Given that the NOI is $108,000 and the purchase price is $1,000,000:
Overall Rate of Return = $108,000 / $1,000,000
b. To calculate the debt coverage ratio, you need to divide the Net Operating Income (NOI) by the annual debt service (interest-only payment).
Debt Coverage Ratio = NOI / Annual Debt Service
Given that the NOI is $108,000 and the annual debt service is the interest-only payment, which is $700,000 * 10% = $70,000:
Debt Coverage Ratio = $108,000 / $70,000
c. To calculate the largest loan you can obtain, considering a debt service coverage ratio of at least 1.2, you need to divide the Net Operating Income (NOI) by 1.2.
Largest Loan = NOI / Debt Service Coverage Ratio
Given that the NOI is $108,000 and the debt service coverage ratio is 1.2:
Largest Loan = $108,000 / 1.2
a. To calculate the overall rate of return or cap rate, divide the net operating income (NOI) by the purchase price.
Cap rate = NOI / Purchase price
= $108,000 / $1,000,000
= 0.108 or 10.8%
b. To calculate the debt coverage ratio, divide the net operating income (NOI) by the annual interest payment on the loan.
Debt coverage ratio = NOI / Annual interest payment
= $108,000 / ($700,000 * 10%)
= $108,000 / $70,000
= 1.54
c. To calculate the largest loan that can be obtained, use the debt service coverage ratio formula and solve for the loan amount.
Debt service coverage ratio = NOI / (Loan amount * Interest rate)
1.2 = $108,000 / (Loan amount * 10%)
1.2 = $108,000 / (Loan amount * 0.1)
1.2 * (Loan amount * 0.1) = $108,000
0.12 * Loan amount = $108,000
Loan amount = $108,000 / 0.12
Loan amount = $900,000
So, the largest loan that can be obtained is $900,000.