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Real estate analysts and investors alike need to understand the risk/return profiles of investment opportunities at revitalization sites as well as the need and market niche of traditional equity players in the commercial marketplace for potentially contaminated sites. Economic risk analysis makes investment decision-making easier for developers and other equity investors at the same time as it provides lenders with the certainty that eases investors' access to debt capital.

Investors in real estate ventures, including revitalization sites, start with the basics: the current income, the current expenses, followed by an analysis of what can be done to increase the income and potentially decrease the expenses. In general, there are six main variables associated with income producing properties. Those variables are:

All properties can be valued according to the rent that they might potentially generate. Net Operating Income (NOI) is calculated using the actual gross rental income minus a factor for vacancy, usually 5 percent or the actual vacancy rate if it is higher. If there is something unusual with the rent revenue, then a projected rent revenue can be used. One condition may be a vacant commercial space the investor wants delivered vacant because there is a tenant for the space. Another potential anomaly would be that the current owner has been warehousing the vacant residential space to make the property more attractive for conversion. Situations like this would warrant using a projected rent roll - a register of rents including the names of tenants and the amount of rent they pay.

A rental figure with a vacancy factor built in is then increased by any ancillary income the property generates. The building may have a laundry room generating income, garage space that has its own income flow, or a roof that can be rented out to a cellular phone company for antenna placement. This additional income is added to the rental figure. This total is called the Effective Gross Income (EGI).

The next step is to look at the expense side of the equation. All of the fixed expenses, taxes, insurance, utilities, etc. should be totaled along with any variable expenses. A management fee factor of 5 to 10 percent should be used (even if management is done in-house). A one-tenant commercial property will have a lower management cost than a 200-unit apartment house, although the EGI could easily be similar.

In dealing with larger properties, an engineering report can be prepared to estimate the remaining useful life of all the mechanical systems. A reserve account should be funded out of the monthly cash flow to be sure there is money available as systems need to be replaced or upgraded. An additional cost can be long-term monitoring or operation and maintenance of a remediation system. Finally, the last variable expense used is a mechanical system replacement reserve. If the engineering report yields no unusual or immediate issues, a factor of 2 percent of the rent revenue is usually used.

Subtracting the total of all these expenses from the EGI yields the NOI. That is,

Net Operating Income = Effective Gross Income - Expenses

It is important that the investor anticipate the calculations the lender will use to approve the financing. The lender will usually assess the debt to be incurred, the value of the property, and the NOI. In other words, what margin of error in the analysis should there be? After expenses are paid and the mortgage payment is made, what’s left? From the investor’s viewpoint, this is his monthly profit. From the lender’s standpoint, this is the margin of error that allows the investor to absorb cash flow fluctuations without affecting the investor’s ability to make mortgage payments.

The Debt Coverage Ratio is nothing more than a relationship between the annual debt service (the annual payment on borrowed money) and the NOI, i.e. the NOI divided by the monthly debt payment. The type of property, the track record of the investor, and the comfort level of the lender will determine what Debt Coverage Ratio will be set for the project. This ratio seldom is allowed to drop below 1.25. This actually means for every dollar of annual debt payment, there is $1.25 of NOI available to pay it.

The cap rate is a ratio of the NOI and the listing or purchase price. This rate is then compared to other similar properties in the area. Comparing sale prices alone, as you would with single-family homes, is problematic because of differences in rent roll and operating expenses. These factors can vary greatly from one property to another making a sales comparison difficult or inaccurate. The cap rate, based on NOI, accounts for income and expense variations among properties.

If the NOI of the property is $50,000 and the cap rate for this type of property is approximately 1:10, then market value for the property should be $500,000. The $50,000 NOI is divided by the cap rate of 1:10. If the investor believes that property improvements can increase the NOI up to $60,000, the value can be increased from $500,000 to $600,000.

When looking at the financing on a project, both the investor and the lender need to know what the minimum percentage of projected income is needed for the project to break even. The lower the percentage, the stronger the project is. The calculation is a simple ratio. The numerator is the sum of all fixed and variable expenses and the debt payment (the factor for replacement of reserves is not included). The numerator is divided by the gross rental income yielding the fraction of income needed to break even.

Any investor, no matter how large or small, will need to know what yield he is getting on his investment. Take the annual NOI, subtract the annual debt payment, and then divide it by the cash investment of the investor. This is the Return on Investment (ROI), that is:

Return on Investment (ROI) = (Annual Net Operating Income [NOI] – Annual Debt Payment) / Cash Investment

The lender will also be interested in this number. If the return is not reasonable, the lender will question the investor’s commitment to the project.

This is the relationship between the appraised value and the loan amount. The LTV is used in conjunction with the other 5 variables, Net Operating Income, Debt Coverage Ratio, Cap Rate, Break Even Ratio, and Cash on Cash Return, in finalizing the feasibility of the project. If the investor is putting 25 percent down on the project and the debt coverage ratio or the break-even ratio is too low, than the price is too high. With strong ratios (higher down payments), it is possible to find a source of funds that will consider a higher mortgage amount.