CRE Variables

What is Net Operating Income (NOI) in CRE analysis?

Definition:

\[ \mathrm{NOI}=\mathrm{Gross\ Rental\ Income}+\mathrm{Other\ Income}-\mathrm{Operating\ Expenses} \]

Exclusions:

• Debt service
• Income taxes
• Depreciation
• CapEx

NOI focuses on property-level operating performance before financing and non-cash accounting items.

What is Cap Rate and how is it interpreted?

Definition:

\[ \text{Cap Rate}=\frac{\text{NOI}}{\text{Property Value}} \]

Valuation form:

\[ \text{Property Value}=\frac{\text{NOI}}{\text{Cap Rate}} \]

Interpretation:

Cap Rate represents the unlevered yield on a property — the annual return an investor would earn if the property were purchased entirely with cash.

Economic intuition:

\[ \text{Cap Rate} \approx r-g \]

Where:

• \( r \) = required rate of return
• \( g \) = expected NOI growth

Directionality & Perspective:

Investor (Buyer):

• Higher cap rate → higher expected return
• Usually reflects higher risk or weaker growth
• Attractive from yield standpoint, but riskier

Owner (Equity Holder):

• Lower cap rate → higher property valuation
• Cap rate compression increases equity value
• Generally beneficial for existing owners

Lender (Credit Context):

• Higher cap rate → lower collateral value
• Increases LTV
• Raises credit risk
• Cap rate expansion is negative for bank portfolios

How is debt service calculated for interest-only and amortizing structures?

Interest-only approximation:

\[ \mathrm{Debt\ Service}\approx \mathrm{Loan\ Balance}\times \mathrm{Interest\ Rate} \]

Amortizing payment:

\[ \mathrm{PMT}=\frac{rL}{1-(1+r)^{-n}} \]

Where \(r\) is the periodic rate, \(L\) is loan balance, and \(n\) is number of periods.

Directionality:

• Debt Service: lower is generally good for coverage; higher is generally bad for coverage.

What is DSCR and how is it interpreted in CRE underwriting?

Debt Service Coverage Ratio (DSCR):

\[ \text{DSCR}=\frac{\text{NOI}}{\text{Debt Service}} \]

Interpretation:

• DSCR measures how many times the property’s operating income covers required debt payments.
• Think of DSCR as a “cash flow cushion” for paying the loan.

Directionality (credit lens):

• Higher DSCR is generally better (more coverage / more buffer).
• Lower DSCR is worse; as DSCR approaches 1.0, the borrower has little margin for NOI shocks.

Quick intuition:

• \( \text{DSCR}=1.25 \) means NOI covers debt service by 25%.
• \( \text{DSCR}<1.0 \) implies NOI does not fully cover debt service.

What is LTV and how is it interpreted in CRE underwriting?

Loan-to-Value (LTV):

\[ \text{LTV}=\frac{\text{Loan Balance}}{\text{Property Value}} \]

Interpretation:

• LTV measures collateral protection—how much equity cushion exists below the loan.
• Lower LTV implies more borrower equity and less loss severity risk in a downturn.

Directionality (credit lens):

• Lower LTV is generally better (more collateral support).
• Higher LTV is worse (less equity buffer; more sensitivity to cap rate expansion / value declines).

Link to cap rates (simple, no tangent):

• If cap rates rise, property value tends to fall → LTV rises (all else equal).

How is weighted average spread measured for a CRE portfolio?

\[ \mathrm{WA\ Spread}=\frac{\sum_i \left(\mathrm{Spread}_i\times \mathrm{Balance}_i\right)}{\sum_i \mathrm{Balance}_i} \]

Directionality:

• WA Spread: context-dependent; moderately higher can be good for margin, but excessively high can indicate higher risk. Compressed spread is generally weaker for earnings.

How do key CRE credit metrics interact under stress?

• If NOI declines by 10% and debt service is fixed, then DSCR declines by 10%.
• If NOI declines by 10% and cap rate is unchanged, then property value declines by 10%.
• If property value declines by 10% and loan balance is unchanged, then LTV increases by approximately 11.1%:

\[ \frac{1}{0.9}-1\approx 0.111 \]

• NOI \(\downarrow\) \(\Rightarrow\) DSCR \(\downarrow\) \(\Rightarrow\) PD risk \(\uparrow\).
• Value \(\downarrow\) \(\Rightarrow\) LTV \(\uparrow\) \(\Rightarrow\) LGD risk \(\uparrow\).

Good vs bad direction summary:

• Good: NOI up, DSCR up, Value up, LTV down.
• Bad: NOI down, DSCR down, Value down, LTV up.

What high-level credit framework links these stressed metrics to expected loss?

\[ \mathrm{Expected\ Loss}=\mathrm{PD}\times \mathrm{LGD}\times \mathrm{EAD} \]

Directionality (all else equal):

• PD: lower is good; higher is bad.
• LGD: lower is good; higher is bad.
• EAD: lower is good for loss exposure; higher is bad for loss exposure.
• Expected Loss: lower is good; higher is bad.