Goals
    • Introduce Business Economics, 
      Terminology and Drafting
       –Discuss Finance Terms and Business Impacts
       –Give Examples of Practical Effect or 
         Implementation of These Terms
       –Give Specific Drafting Examples and Discuss 
                                                      2
               How Much Do You Pay?
                  (What is Fair Market Value)
    Capitalization Rate (Cap Rate)
    • “Cap Rate” the return demanded by investor on the asset
    • Cap Rate developed pre-computer
    • Cap Rate = Net Operating Income (NOI)(Stabilized)
                   Purchase Price
      Purchase = Net Operating Income (NOI)(Stabilized)
      Price        Cap Rate
    • Multiplier = 1/Cap Rate
    • e.g., If Cap Rate = 10%
      Purchase Price = 10 (=1/.10) x Income
               If Cap Rate = 5%
      Purchase Price = 20 (=1/.05) x Income
                                                    3
                 How Much Do You Pay?
                    (What is Fair Market Value)
     Why do you care about Cap Rate?
       1.  Cap Rate increase (decrease) decreases (increases) sale 
           price of asset and therefore affects return on investment
       2.  Many other and better valuation methods 
          •   Discounted cash flow
          •   Internal rate of return
       3.  The best spreadsheet does not determine who wins in a real 
           estate investment  or  who maximizes their return
       4.  Cap Rate adjustments by rating agencies
       5.  Cap Rate change effects on value are minimized as length of  
           holding period increases
                                                               4
                                            How Much Do You Pay?
                                                  (What is Fair Market Value)
            Required Increase in NOI as a percentage to maintain constant Fair Market 
                                              Value given an increase in Cap Rates
                      Cap                              NOI 
                      Rate                             Increase
                      New   /               5%              6%               8%             10%              12%
                      Old
                           4%              25%             50%             100%             150%            200%
                           5%                              20%              60%             100%            140%
                           7%                                               14%             43%              72%
                           9%                                                                11%             33%
                          10%                                                                                20%
                                                                                                                                       5
                 How Do You Finance ?
               (Debt Covenants in Loan Documents)
    Debt Service Coverage Ratio (DSCR)
    Definition:  The ratio of net operating income (NOI) to the annual debt service 
       on a property     DSCR  =  NOI / annual debt service
    •  Often used in financial covenants to:
       – Impose cash management restrictions (lock box or additional consent 
         requirements)
       – Condition a loan extension
       – Increase or decrease interest rate
       – Allow “earn out” advances
       – Trigger defaults or mandatory reductions in outstanding principal
       – Condition permitted assumptions of loans
       – Release guarantors
       – Release of reserve
       – Requires a reserve to be set up
                                                          6