NET OPERATING INCOME
The first performance measurement is known as net operating income (N.O.I.). Net operating income is the income that remains after all operating expenses have been paid. It is also the amount of income available to service the property’s debt-in other words, to pay on any outstanding loan balances such as a mortgage or seller- financed note. Net operating income is also the numerator in the quotient used to calculate the capitalization rate. N.O.I. is calculated as follows:
Gross income − total operating expenses = net operating income
The net operating income is a key figure to understand because it is needed to calculate a property’s cap rate. It can also be used to estimate the approximate sales price of an income-producing property. For example, if you know that office buildings in a given market are selling for an estimated cap rate of eight (8 percent), and the N.O.I. from a particular building is $240,000, then the estimated selling price for the building should be approximately $3 million. The calculation is made as follows:
Net operating income = sales price / Cap rate
$240,000 / $3,000,000 =.08 (Net operating income)
DEBT SERVICE COVERAGE RATIO
The second performance measurement is known as the debt service coverage ratio (D.S.C.R.). The D.S.C.R. is a ratio that measures the relationship between available cash after operating expenses have been paid and the cash required to make the required debt payments. This ratio is especially important to lenders, as they want to ensure that the property being considered for investment purposes will generate enough cash to cover any and all debt obligations. In other words, they want and need to be assured that the real estate is throwing off enough cash to repay the loan. The debt service coverage ratio is calculated as follows:
Debt service coverage ratio = net operating income / principal + interest = D.S.C.R.
The ratio is a simple measure of the relationship of cash generated from an investment to the debt required to pay for that investment. The minimum D.S.C.R. varies from lender to lender, but in general it can be as low as 0.75 or as high as 1.40. Most lenders look for a minimum D.S.C.R. of 1.00 to 1.20.
OPERATING EFFICIENCY RATIO
The next performance measurement is referred to as the operating efficiency ratio (OER). The OER is a computation that measures the operating expenses of an investment property relative to its size. The ratio is useful for both multi-family and commercial real estate properties. It is calculated as the ratio of total operating expenses to total square feet. The result provides a measure of how efficiently the property can be operated. The lower the number, the less it costs to manage and operate the property. The calculation is made as follows:
Operating efficiency ratio = total operating expenses / square feet = OER