When analysing real estate transactions, from either an equity or debt perspective, there are numerous terms to be familiar with. This terminology usually relates to funding of real estate transactions, whether it is private equity firms or developers trying to raise debt funding to acquire properties, or lenders considering whether to lend funds to these firms. In this article, I will explore what these terms mean, and then use some examples to see how they are used in practice.
LTV
LTV (Loan to Value) is the proportion of a property purchase cost that is funded by loans. For example, consider a PE fund requires £100m to acquire a building; the firm may seek 70% of this amount to be funded by loans, and 30% to be funded by equity. Under this scenario, the PE firm will go to a bank or private credit fund and apply for £70m of funding, whilst committing to put in £30m of equity funding. The majority of developments tend to have a LTV of 60-70%, although this depends on the particular property sector being targeted other similar deals in the market.
NOI
NOI (Net Operating Income) is a profitability metric of a real estate firm which takes the rental income received less operating expenses such as insurance premiums, utilities, taxes, repair and maintenance costs and property management fees. NOI is a pre-tax figure, which excludes interest expenses and principal payments, capex, depreciation and amortization. It is comparable to an EBIT figure used in other industries. Lenders use NOI as one of the metrics to inform them of what level of funding they can extend on the purchase or construction of a property. Let’s assume the property listed above generates revenue of £10m each year, and generates a NOI of £7m, this means the NOI margin is 70%.
Cap rate
NOI is used to calculate the cap (capitalization) rate of a property and is found by dividing the NOI by a property’s purchase price. Based on this example, the NOI is £7m, and purchase price of the building is £100m, giving the investor a buy-in cap rate of 7%. If the building were to decline in value after purchase, say to £90m, this means the cap rate has increased to 7.8%, because cap rates and property values are inversely correlated.
Debt yield
Debt yield is a function of NOI and the amount of debt going to fund a particular development or property. It is calculated as NOI divided by the initial debt balance. For example, assuming the shopping centre purchase price is £100m, and £70m debt is used to fund the development. This results in a debt yield of 10%, or £7m divided by £70m.
Cap rate and debt yield relationship
It is important to compare the debt yield to the cap rate. If cap rate exceeds the debt yield, this means the debt is now worth more than the property and the property is underwater. For example, if the cap rate were to increase to 11%, this means the property has fallen to £63.6m, whilst the debt against the property is £70m, leaving a deficit of £6.4m. So even if the lender foreclosed on the property and sold it, they would take a hit of £6.4m.
So now that we have looked at some key real estate metrics, we now need to consider how banks assess how much funding they should lend to real estate ventures.
Debt Service Coverage Ratio
Debt Service Coverage Ratio (DSCR) is a measure of the extent to which a property company can cover its debt and interest commitments through its operating earnings, or NOI. Going back to our example. Assuming a company generated a NOI of £7m, and principal/interest obligations were £5m per year, this results in a DSCR of 1.4 times. Typically lenders require DSCR of between 1.2 and 1.4 times, although some level of margin of safety, or cushioning, is preferred, in case of a downturn in the property cycle where vacancies might increase, some tenants don’t renew their leases and rental income falls.
Interest coverage ratio
Interest coverage measures the extent towards a property’s NOI covers its annual interest obligations. With a NOI of £7m, assume annual interest is £3.5m, the interest coverage is 2 times, which is about the minimum ratio that lenders will be comfortable with. In a market downturn, say interest rates go up, so that interest goes to £4m, and NOI reduces to £6.5m, because of increased operating expenses or a reduction in rental income, the interest coverage ratio drops to 1.6, which becomes higher risk.
This article discusses some of the main terminology in real estate investing. In a future article, I will look at the various types of lending structures that banks and private debt funds extend to real estate companies.