Introduction to Income Property Lender Practices and Underwriting: Chapter I, Section II Dan J. Harkey

Introduction to Income Property Lender Practices and Underwriting

Chapter I, Section II:

Terminology and Application Relating to Income Stream.

Examples added for each key term to illustrate their practical application in underwriting and valuation, making the information more relevant and applicable to your work:

Understanding the components of an income property’s revenue is crucial for accurate valuation and underwriting. This section defines key terms used by lenders, brokers, and appraisers when evaluating the income streams of commercial and multifamily properties. It illustrates their practical application with real-world examples to keep readers engaged.

A. Potential Gross Income (PGI), Scheduled Gross Income, or Proforma Income

Definition: These terms refer to the total income a property is expected to generate if fully occupied at market rents, before deducting any operating expenses.

Example:

Let’s take a closer look at a 20-unit apartment complex with a market rent of $2,000 per unit. This example will help you understand how to calculate PGI in a real-world scenario.
This assumes full occupancy and no concessions.

B. Contract Rent

Definition: The actual rent specified in current leases. It may differ from market rent due to negotiated terms.

Example:

A tenant signed a 5-year lease at $1,800/month two years ago. Market rent is now $2,100/month. The contract rent is still $1,800/month, which is below market.

Adjustment Example:

If the lease includes 2 months of free rent at the start, the effective contract rent over the first year is:

C. Market Rent

Definition: The rent of a property could command in the open market under current conditions.

Example:

A comparable office space in the same submarket leases for $30/sq ft annually. An owner-occupied space of 5,000 sq ft would be valued using:

Valuation Impact Example:

If the property’s existing lease generates $120,000 in annual income, the appraiser may reduce the valuation to reflect the income shortfall relative to market rent.

D. Market Rent vs. Contract Rent – Risk Considerations

Example Scenarios:

A tenant pays $3,000/month in a lease signed during a market peak. Current market rent is $2,400/month. If the tenant vacates, the owner may struggle to replace the income.
A family Member leases space at above-market rent to inflate property income for a sale. This non-arm’s-length transaction may misrepresent actual market value.

E. Escalation Income

Definition: Additional income from lease clauses that pass-through increases in operating costs to tenants.

Example:
A retail lease includes a clause requiring tenants to pay their share of property tax increases. If taxes rise by $10,000 and the tenant’s share is 25%, the escalation income is:

F. Other Income

Definition: Income from sources other than base rent.

Examples:

· Space Rentals:

o Parking: 10 spaces rented at $100/month = $1,000/month or $12,000/year

o Storage units: 5 units at $75/month = $375/month or $4,500/year

· Equipment Rentals:

o Tenants pay $50/month for upgraded HVAC systems = $600/year per unit

· Concessions:

o Coin laundry generates $300/month. If operated by a concessionaire with a 50/50 revenue split, the owner receives $150/month or $1,800/year.

· Utility Resale:

o Owner buys electricity at $0.10/kWh and charges tenants $0.15/kWh. If tenants use 100,000 kWh/year, gross income is $15,000. Net income after cost is:

Income Stream Formulas

1. Potential Gross Income (PGI)

Represents the total income a property could generate if fully leased at market rent.

Formula:
Or, for mixed-use properties:

2. Contract Rent Income

Income based on existing lease agreements, adjusted for concessions.

Formula:

Where concessions may include:

Free rent periods
Tenant improvement allowances
Discounted escalation clauses
Other provisions in the lease, like a go-dark provision, or if the center becomes 50% or more vacant, then the master tenant can vacate.

3. Market Rent Income

Estimated rent for vacant or owner-occupied space based on comparable market data.

Formula:

4. Escalation Income

Additional income from lease clauses that pass through operating cost increases.

Formula:

Example:

5. Other Income

Ancillary income from non-rent sources such as parking, vending, laundry, or utility resale.

Formula:

Examples include:

Parking:
Laundry:
Utilities:

6. Effective Gross Income (EGI)

The actual income expected after accounting for vacancy and collection losses.

Formula:

The actual income expected after accounting for vacancy and collection losses.

Formula:

Or:

Discuss with Jason

Here are examples using each of the income stream formulas from Chapter I, Section II. These are designed to illustrate how the formulas work in practical underwriting scenarios:

Income Stream Formula Examples

1. Potential Gross Income (PGI)

Scenario: A 20-unit apartment building charges market rent of $1,800 per unit per month. This is a common scenario in many urban areas, and understanding the PGI in this context is essential for underwriting such properties.

Calculation:

Explanation: This total annual income assumes full occupancy at market rent, illustrating how potential gross income impacts underwriting decisions in real scenarios.

2. Contract Rent Income

Scenario: A retail center has five tenants. Each pays $5,000/month, but two tenants receive 2 months of free rent as a concession.

Calculation:

Gross annual rent:
Concessions:
Contract Rent Income:

Explanation: Contract rent reflects actual lease terms, adjusted for concessions.

3. Market Rent Income

Scenario: A vacant 3,000 sq ft office space has a market rent of $2.50/sq ft/month.

Calculation:

Explanation: This is the estimated annual income if the space were leased at current market rates.

4. Escalation Income

Scenario: A lease includes a clause where tenants pay their share of property tax increases. The total increase is $12,000, and a tenant occupies 25% of the building.

Calculation:

Explanation: Escalation clauses help owners recover increased operating costs.

5. Other Income

Scenario: A multifamily property earns additional income from:

Parking: 10 spaces at $100/month
Laundry: $4,800/year net
Vending: $1,200/year net

Calculation:

Parking
Total Other Income:

Explanation: These ancillary sources contribute to the property’s total income.

6. Effective Gross Income (EGI)

Scenario:

PGI = $432,000
Other Income = $18,000
Vacancy & Collection Loss = 8%

Calculation

Explanation: EGI reflects the actual income expected after accounting for vacancies and collection issues.

Here’s a case study that integrates the income stream formulas and examples from Chapter II, Section III. This can be used to illustrate how an appraiser or underwriter would evaluate a real-world income property:

Case Study: Underwriting a Mixed-Use Income Property

Property Overview:
A mixed-use building in Orange County, California, contains:

10 residential units (each 900 sq ft)
2 retail storefronts (each 1,500 sq ft)
8 parking spaces
Coin-operated laundry and vending machines

Step 1: Calculate Potential Gross Income (PGI)

Residential Units:
Retail Units:
Total PGI:

Step 2: Adjust for Contract Rent

One retail tenant has a lease at $2.00/sq ft with 2 months free rent.

Adjusted Contract Rent:
The second retail unit is vacant and will be estimated at market rent.

Step 3: Estimate Market Rent for Vacant Space

Vacant retail unit:

Step 4: Calculate Escalation Income

Property taxes increased by $8,000. Each retail tenant pays 50%.

Step 5: Calculate Other Income

Parking:
Laundry:
Net income = $3,600
Vending:
Net income = $1,200
Total Other Income:

Step 6: Calculate Effective Gross Income (EGI)

PGI + Other Income:
Vacancy & Collection Loss (7%):
EGI:

Conclusion

The appraiser determines the Effective Gross Income (EGI) to be $320,292, which becomes the foundation for further analysis, including operating expense deductions, net operating income (NOI) calculation, and ultimately, property valuation and loan underwriting.

A clear explanation of how to calculate Net Operating Income (NOI), building directly on the previous examples:

Calculating Net Operating Income (NOI)

Net Operating Income (NOI) is a key metric in income property underwriting. It represents the income generated by a property after operating expenses are deducted from the Effective Gross Income (EGI). NOI is used to assess a property’s profitability and is central to determining its value using the income capitalization approach.

Formula

Example: Continuing the Mixed-Use Property Case Study

From the previous case study, we calculated:

EGI = $320,292
Operating Expenses = $110,000 (includes property taxes, insurance, maintenance, utilities, management fees, etc.)

Calculation:

Explanation:

EGI accounts for all income sources (rent, other income) minus vacancy and collection losses.
Operating Expenses include all costs necessary to operate and maintain the property, but exclude debt service (loan payments), depreciation, and capital expenditures.
NOI reflects the property’s ability to generate income from operations alone and is used to:

· Evaluate investment performance

· Calculate the capitalization rate (Cap Rate): Cap rate = / Property Value

· Determine maximum loan amounts based on lender-required Debt Service Coverage Ratio (DSCR): DSCR + NOI / Annual Debt Service

Here is a short quiz on Net Operating Income (NOI) calculation, designed to test understanding of the concept and its application in income property underwriting:

Quiz: Net Operating Income (NOI)

Question 1

A property has an Effective Gross Income (EGI) of $500,000 and operating expenses of $180,000. What is the Net Operating Income?

A) $320,000
B) $680,000
C) $500,000
D) $180,000

Question 2

Which of the following is excluded from operating expenses when calculating NOI?

A) Property management fees
B) Utilities
C) Debt service (loan payments)
D) Repairs and maintenance

Question 3

A property has a PGI of $600,000, Other Income of $40,000, and a vacancy rate of 10%. Operating expenses total $200,000. What is the NOI?

A) $340,000
B) $380,000
C) $400,000
D) $420,000

Question 4

Why is NOI important in income property underwriting?

A) It determines the Borrower’s credit score
B) It reflects the property’s profitability before financing costs
C) It includes depreciation and amortization
D) It is used to calculate the property’s tax liability

Question 5

A lender requires a minimum DSCR of 1.25. If a property has an NOI of $250,000, what is the maximum allowable annual debt service?

A) $200,000
B) $312,500
C) $250,000
D) $180,000

Here’s the answer key with explanations for the NOI Calculation Quiz:

Answer Key: Net Operating Income (NOI) Quiz

Question 1

EGI = $500,000, Operating Expenses = $180,000

NOI = EGI - Operating Expenses

✅ Correct Answer: A

Explanation: NOI is calculated by subtracting operating expenses from adequate gross income. It reflects the income generated before financing costs.

Question 2

Which is excluded from operating expenses?

✅ Correct Answer: C) Debt service (loan payments)

Explanation: Operating expenses include costs like property management, utilities, and maintenance. Debt service is not included in NOI—it’s considered a financing cost and is used later in cash flow analysis.

Question 3

PGI = $600,000, Other Income = $40,000, Vacancy Rate = 10%, Operating Expenses = $200,000

Step 1: Calculate EGI

Step 2: Calculate NOI

✅ Correct Answer: B

Explanation: EGI accounts for vacancy loss. NOI is the amount remaining after operating expenses are deducted.

Question 4

Why is NOI important?

✅ Correct Answer: B) It reflects the property’s profitability before financing costs

Explanation: NOI is a core metric in underwriting and valuation. It shows how much income the property generates from operations alone, independent of financing structure.

Question 5

Introduction to Income Property Lender Practices and Underwriting

Chapter I, Section II:

Terminology and Application Relating to Income Stream.

Examples added for each key term to illustrate their practical application in underwriting and valuation, making the information more relevant and applicable to your work:

A. Potential Gross Income (PGI), Scheduled Gross Income, or Proforma Income

Definition: These terms refer to the total income a property is expected to generate if fully occupied at market rents, before deducting any operating expenses.

Example:

B. Contract Rent

Definition: The actual rent specified in current leases. It may differ from market rent due to negotiated terms.

Example:

A tenant signed a 5-year lease at $1,800/month two years ago. Market rent is now $2,100/month. The contract rent is still $1,800/month, which is below market.

Adjustment Example:

If the lease includes 2 months of free rent at the start, the effective contract rent over the first year is:

C. Market Rent

Definition: The rent of a property could command in the open market under current conditions.

Example:

A comparable office space in the same submarket leases for $30/sq ft annually. An owner-occupied space of 5,000 sq ft would be valued using:

Valuation Impact Example:

If the property’s existing lease generates $120,000 in annual income, the appraiser may reduce the valuation to reflect the income shortfall relative to market rent.

D. Market Rent vs. Contract Rent – Risk Considerations

Example Scenarios:

A tenant pays $3,000/month in a lease signed during a market peak. Current market rent is $2,400/month. If the tenant vacates, the owner may struggle to replace the income.
A family Member leases space at above-market rent to inflate property income for a sale. This non-arm’s-length transaction may misrepresent actual market value.

E. Escalation Income

Definition: Additional income from lease clauses that pass-through increases in operating costs to tenants.

Example:
A retail lease includes a clause requiring tenants to pay their share of property tax increases. If taxes rise by $10,000 and the tenant’s share is 25%, the escalation income is:

F. Other Income

Definition: Income from sources other than base rent.

Examples:

· Space Rentals:

o Parking: 10 spaces rented at $100/month = $1,000/month or $12,000/year

o Storage units: 5 units at $75/month = $375/month or $4,500/year

· Equipment Rentals:

o Tenants pay $50/month for upgraded HVAC systems = $600/year per unit

· Concessions:

o Coin laundry generates $300/month. If operated by a concessionaire with a 50/50 revenue split, the owner receives $150/month or $1,800/year.

· Utility Resale:

o Owner buys electricity at $0.10/kWh and charges tenants $0.15/kWh. If tenants use 100,000 kWh/year, gross income is $15,000. Net income after cost is:

Income Stream Formulas

1. Potential Gross Income (PGI)

Represents the total income a property could generate if fully leased at market rent.

Formula:
Or, for mixed-use properties:

2. Contract Rent Income

Income based on existing lease agreements, adjusted for concessions.

Formula:

Where concessions may include:

Free rent periods
Tenant improvement allowances
Discounted escalation clauses
Other provisions in the lease, like a go-dark provision, or if the center becomes 50% or more vacant, then the master tenant can vacate.

3. Market Rent Income

Estimated rent for vacant or owner-occupied space based on comparable market data.

Formula:

4. Escalation Income

Additional income from lease clauses that pass through operating cost increases.

Formula:

Example:

5. Other Income

Ancillary income from non-rent sources such as parking, vending, laundry, or utility resale.

Formula:

Examples include:

Parking:
Laundry:
Utilities:

6. Effective Gross Income (EGI)

The actual income expected after accounting for vacancy and collection losses.

Formula:

Or:

Here are examples using each of the income stream formulas from Chapter I, Section II. These are designed to illustrate how the formulas work in practical underwriting scenarios:

Income Stream Formula Examples

1. Potential Gross Income (PGI)

Calculation:

Explanation: This total annual income assumes full occupancy at market rent, illustrating how potential gross income impacts underwriting decisions in real scenarios.

2. Contract Rent Income

Scenario: A retail center has five tenants. Each pays $5,000/month, but two tenants receive 2 months of free rent as a concession.

Calculation:

Gross annual rent:
Concessions:
Contract Rent Income:

Explanation: Contract rent reflects actual lease terms, adjusted for concessions.

3. Market Rent Income

Scenario: A vacant 3,000 sq ft office space has a market rent of $2.50/sq ft/month.

Calculation:

Explanation: This is the estimated annual income if the space were leased at current market rates.

4. Escalation Income

Scenario: A lease includes a clause where tenants pay their share of property tax increases. The total increase is $12,000, and a tenant occupies 25% of the building.

Calculation:

Explanation: Escalation clauses help owners recover increased operating costs.

5. Other Income

Scenario: A multifamily property earns additional income from:

Parking: 10 spaces at $100/month
Laundry: $4,800/year net
Vending: $1,200/year net

Calculation:

Parking
Total Other Income:

Explanation: These ancillary sources contribute to the property’s total income.

6. Effective Gross Income (EGI)

Scenario:

PGI = $432,000
Other Income = $18,000
Vacancy & Collection Loss = 8%

Calculation

Explanation: EGI reflects the actual income expected after accounting for vacancies and collection issues.

Case Study: Underwriting a Mixed-Use Income Property

Property Overview:
A mixed-use building in Orange County, California, contains:

10 residential units (each 900 sq ft)
2 retail storefronts (each 1,500 sq ft)
8 parking spaces
Coin-operated laundry and vending machines

Step 1: Calculate Potential Gross Income (PGI)

Residential Units:
Retail Units:
Total PGI:

Step 2: Adjust for Contract Rent

One retail tenant has a lease at $2.00/sq ft with 2 months free rent.

Adjusted Contract Rent:
The second retail unit is vacant and will be estimated at market rent.

Step 3: Estimate Market Rent for Vacant Space

Vacant retail unit:

Step 4: Calculate Escalation Income

Property taxes increased by $8,000. Each retail tenant pays 50%.

Step 5: Calculate Other Income

Parking:
Laundry:
Net income = $3,600
Vending:
Net income = $1,200
Total Other Income:

Step 6: Calculate Effective Gross Income (EGI)

PGI + Other Income:
Vacancy & Collection Loss (7%):
EGI:

Conclusion

A clear explanation of how to calculate Net Operating Income (NOI), building directly on the previous examples:

Calculating Net Operating Income (NOI)

Formula

Example: Continuing the Mixed-Use Property Case Study

From the previous case study, we calculated:

EGI = $320,292
Operating Expenses = $110,000 (includes property taxes, insurance, maintenance, utilities, management fees, etc.)

Calculation:

Explanation:

EGI accounts for all income sources (rent, other income) minus vacancy and collection losses.
Operating Expenses include all costs necessary to operate and maintain the property, but exclude debt service (loan payments), depreciation, and capital expenditures.
NOI reflects the property’s ability to generate income from operations alone and is used to:

· Evaluate investment performance

· Calculate the capitalization rate (Cap Rate): Cap rate = / Property Value

· Determine maximum loan amounts based on lender-required Debt Service Coverage Ratio (DSCR): DSCR + NOI / Annual Debt Service

Here is a short quiz on Net Operating Income (NOI) calculation, designed to test understanding of the concept and its application in income property underwriting:

Quiz: Net Operating Income (NOI)

Question 1

A property has an Effective Gross Income (EGI) of $500,000 and operating expenses of $180,000. What is the Net Operating Income?

A) $320,000
B) $680,000
C) $500,000
D) $180,000

Question 2

Which of the following is excluded from operating expenses when calculating NOI?

A) Property management fees
B) Utilities
C) Debt service (loan payments)
D) Repairs and maintenance

Question 3

A property has a PGI of $600,000, Other Income of $40,000, and a vacancy rate of 10%. Operating expenses total $200,000. What is the NOI?

A) $340,000
B) $380,000
C) $400,000
D) $420,000

Question 4

Why is NOI important in income property underwriting?

Question 5

A lender requires a minimum DSCR of 1.25. If a property has an NOI of $250,000, what is the maximum allowable annual debt service?

A) $200,000
B) $312,500
C) $250,000
D) $180,000

Here’s the answer key with explanations for the NOI Calculation Quiz:

Answer Key: Net Operating Income (NOI) Quiz

Question 1

EGI = $500,000, Operating Expenses = $180,000

NOI = EGI - Operating Expenses

✅ Correct Answer: A

Explanation: NOI is calculated by subtracting operating expenses from adequate gross income. It reflects the income generated before financing costs.

Question 2

Which is excluded from operating expenses?

✅ Correct Answer: C) Debt service (loan payments)

Question 3

PGI = $600,000, Other Income = $40,000, Vacancy Rate = 10%, Operating Expenses = $200,000

Step 1: Calculate EGI

Step 2: Calculate NOI

✅ Correct Answer: B

Explanation: EGI accounts for vacancy loss. NOI is the amount remaining after operating expenses are deducted.

Question 4

Why is NOI important?

✅ Correct Answer: B) It reflects the property’s profitability before financing costs

Explanation: NOI is a core metric in underwriting and valuation. It shows how much income the property generates from operations alone, independent of financing structure.

Question 5

NOI = $250,000, Required DSCR = 1.25

Formula: Maximum Debt Service = NOI / DSCR + 250,000 / 1.25 = $200,000

✅ Correct Answer: A

Explanation: To meet a DSCR of 1.25, the annual debt service must not exceed $200,000. This ensures the property generates enough income to cover debt obligations with a safety margin.

Introduction to Income Property Lender Practices and Underwriting

Chapter I, Section II:

Terminology and Application Relating to Income Stream.

Examples added for each key term to illustrate their practical application in underwriting and valuation, making the information more relevant and applicable to your work:

A. Potential Gross Income (PGI), Scheduled Gross Income, or Proforma Income

Definition: These terms refer to the total income a property is expected to generate if fully occupied at market rents, before deducting any operating expenses.

Example:

B. Contract Rent

Definition: The actual rent specified in current leases. It may differ from market rent due to negotiated terms.

Example:

A tenant signed a 5-year lease at $1,800/month two years ago. Market rent is now $2,100/month. The contract rent is still $1,800/month, which is below market.

Adjustment Example:

If the lease includes 2 months of free rent at the start, the effective contract rent over the first year is:

C. Market Rent

Definition: The rent of a property could command in the open market under current conditions.

Example:

A comparable office space in the same submarket leases for $30/sq ft annually. An owner-occupied space of 5,000 sq ft would be valued using:

Valuation Impact Example:

If the property’s existing lease generates $120,000 in annual income, the appraiser may reduce the valuation to reflect the income shortfall relative to market rent.

D. Market Rent vs. Contract Rent – Risk Considerations

Example Scenarios:

A tenant pays $3,000/month in a lease signed during a market peak. Current market rent is $2,400/month. If the tenant vacates, the owner may struggle to replace the income.
A family Member leases space at above-market rent to inflate property income for a sale. This non-arm’s-length transaction may misrepresent actual market value.

E. Escalation Income

Definition: Additional income from lease clauses that pass-through increases in operating costs to tenants.

Example:
A retail lease includes a clause requiring tenants to pay their share of property tax increases. If taxes rise by $10,000 and the tenant’s share is 25%, the escalation income is:

F. Other Income

Definition: Income from sources other than base rent.

Examples:

· Space Rentals:

o Parking: 10 spaces rented at $100/month = $1,000/month or $12,000/year

o Storage units: 5 units at $75/month = $375/month or $4,500/year

· Equipment Rentals:

o Tenants pay $50/month for upgraded HVAC systems = $600/year per unit

· Concessions:

o Coin laundry generates $300/month. If operated by a concessionaire with a 50/50 revenue split, the owner receives $150/month or $1,800/year.

· Utility Resale:

o Owner buys electricity at $0.10/kWh and charges tenants $0.15/kWh. If tenants use 100,000 kWh/year, gross income is $15,000. Net income after cost is:

Income Stream Formulas

1. Potential Gross Income (PGI)

Represents the total income a property could generate if fully leased at market rent.

Formula:
Or, for mixed-use properties:

2. Contract Rent Income

Income based on existing lease agreements, adjusted for concessions.

Formula:

Where concessions may include:

Free rent periods
Tenant improvement allowances
Discounted escalation clauses
Other provisions in the lease, like a go-dark provision, or if the center becomes 50% or more vacant, then the master tenant can vacate.

3. Market Rent Income

Estimated rent for vacant or owner-occupied space based on comparable market data.

Formula:

4. Escalation Income

Additional income from lease clauses that pass through operating cost increases.

Formula:

Example:

5. Other Income

Ancillary income from non-rent sources such as parking, vending, laundry, or utility resale.

Formula:

Examples include:

Parking:
Laundry:
Utilities:

6. Effective Gross Income (EGI)

The actual income expected after accounting for vacancy and collection losses.

Formula:

Or:

Here are examples using each of the income stream formulas from Chapter I, Section II. These are designed to illustrate how the formulas work in practical underwriting scenarios:

Income Stream Formula Examples

1. Potential Gross Income (PGI)

Calculation:

Explanation: This total annual income assumes full occupancy at market rent, illustrating how potential gross income impacts underwriting decisions in real scenarios.

2. Contract Rent Income

Scenario: A retail center has five tenants. Each pays $5,000/month, but two tenants receive 2 months of free rent as a concession.

Calculation:

Gross annual rent:
Concessions:
Contract Rent Income:

Explanation: Contract rent reflects actual lease terms, adjusted for concessions.

3. Market Rent Income

Scenario: A vacant 3,000 sq ft office space has a market rent of $2.50/sq ft/month.

Calculation:

Explanation: This is the estimated annual income if the space were leased at current market rates.

4. Escalation Income

Scenario: A lease includes a clause where tenants pay their share of property tax increases. The total increase is $12,000, and a tenant occupies 25% of the building.

Calculation:

Explanation: Escalation clauses help owners recover increased operating costs.

5. Other Income

Scenario: A multifamily property earns additional income from:

Parking: 10 spaces at $100/month
Laundry: $4,800/year net
Vending: $1,200/year net

Calculation:

Parking
Total Other Income:

Explanation: These ancillary sources contribute to the property’s total income.

6. Effective Gross Income (EGI)

Scenario:

PGI = $432,000
Other Income = $18,000
Vacancy & Collection Loss = 8%

Calculation

Explanation: EGI reflects the actual income expected after accounting for vacancies and collection issues.

Case Study: Underwriting a Mixed-Use Income Property

Property Overview:
A mixed-use building in Orange County, California, contains:

10 residential units (each 900 sq ft)
2 retail storefronts (each 1,500 sq ft)
8 parking spaces
Coin-operated laundry and vending machines

Step 1: Calculate Potential Gross Income (PGI)

Residential Units:
Retail Units:
Total PGI:

Step 2: Adjust for Contract Rent

One retail tenant has a lease at $2.00/sq ft with 2 months free rent.

Adjusted Contract Rent:
The second retail unit is vacant and will be estimated at market rent.

Step 3: Estimate Market Rent for Vacant Space

Vacant retail unit:

Step 4: Calculate Escalation Income

Property taxes increased by $8,000. Each retail tenant pays 50%.

Step 5: Calculate Other Income

Parking:
Laundry:
Net income = $3,600
Vending:
Net income = $1,200
Total Other Income:

Step 6: Calculate Effective Gross Income (EGI)

PGI + Other Income:
Vacancy & Collection Loss (7%):
EGI:

Conclusion

A clear explanation of how to calculate Net Operating Income (NOI), building directly on the previous examples:

Calculating Net Operating Income (NOI)

Formula

Example: Continuing the Mixed-Use Property Case Study

From the previous case study, we calculated:

EGI = $320,292
Operating Expenses = $110,000 (includes property taxes, insurance, maintenance, utilities, management fees, etc.)

Calculation:

Explanation:

EGI accounts for all income sources (rent, other income) minus vacancy and collection losses.
Operating Expenses include all costs necessary to operate and maintain the property, but exclude debt service (loan payments), depreciation, and capital expenditures.
NOI reflects the property’s ability to generate income from operations alone and is used to:

· Evaluate investment performance

· Calculate the capitalization rate (Cap Rate): Cap rate = / Property Value

· Determine maximum loan amounts based on lender-required Debt Service Coverage Ratio (DSCR): DSCR + NOI / Annual Debt Service

Here is a short quiz on Net Operating Income (NOI) calculation, designed to test understanding of the concept and its application in income property underwriting:

Quiz: Net Operating Income (NOI)

Question 1

A property has an Effective Gross Income (EGI) of $500,000 and operating expenses of $180,000. What is the Net Operating Income?

A) $320,000
B) $680,000
C) $500,000
D) $180,000

Question 2

Which of the following is excluded from operating expenses when calculating NOI?

A) Property management fees
B) Utilities
C) Debt service (loan payments)
D) Repairs and maintenance

Question 3

A property has a PGI of $600,000, Other Income of $40,000, and a vacancy rate of 10%. Operating expenses total $200,000. What is the NOI?

A) $340,000
B) $380,000
C) $400,000
D) $420,000

Question 4

Why is NOI important in income property underwriting?

Question 5

A lender requires a minimum DSCR of 1.25. If a property has an NOI of $250,000, what is the maximum allowable annual debt service?

A) $200,000
B) $312,500
C) $250,000
D) $180,000

Here’s the answer key with explanations for the NOI Calculation Quiz:

Answer Key: Net Operating Income (NOI) Quiz

Question 1

EGI = $500,000, Operating Expenses = $180,000

NOI = EGI - Operating Expenses

✅ Correct Answer: A

Explanation: NOI is calculated by subtracting operating expenses from adequate gross income. It reflects the income generated before financing costs.

Question 2

Which is excluded from operating expenses?

✅ Correct Answer: C) Debt service (loan payments)

Question 3

PGI = $600,000, Other Income = $40,000, Vacancy Rate = 10%, Operating Expenses = $200,000

Step 1: Calculate EGI

Step 2: Calculate NOI

✅ Correct Answer: B

Explanation: EGI accounts for vacancy loss. NOI is the amount remaining after operating expenses are deducted.

Question 4

Why is NOI important?

✅ Correct Answer: B) It reflects the property’s profitability before financing costs

Explanation: NOI is a core metric in underwriting and valuation. It shows how much income the property generates from operations alone, independent of financing structure.

Question 5

NOI = $250,000, Required DSCR = 1.25

Formula: Maximum Debt Service = NOI / DSCR + 250,000 / 1.25 = $200,000

✅ Correct Answer: A

Explanation: To meet a DSCR of 1.25, the annual debt service must not exceed $200,000. This ensures the property generates enough income to cover debt obligations with a safety margin.

Introduction to Income Property Lender Practices and Underwriting

Chapter I, Section II:

Terminology and Application Relating to Income Stream.

Examples added for each key term to illustrate their practical application in underwriting and valuation, making the information more relevant and applicable to your work:

A. Potential Gross Income (PGI), Scheduled Gross Income, or Proforma Income

Definition: These terms refer to the total income a property is expected to generate if fully occupied at market rents, before deducting any operating expenses.

Example:

B. Contract Rent

Definition: The actual rent specified in current leases. It may differ from market rent due to negotiated terms.

Example:

A tenant signed a 5-year lease at $1,800/month two years ago. Market rent is now $2,100/month. The contract rent is still $1,800/month, which is below market.

Adjustment Example:

If the lease includes 2 months of free rent at the start, the effective contract rent over the first year is:

C. Market Rent

Definition: The rent of a property could command in the open market under current conditions.

Example:

A comparable office space in the same submarket leases for $30/sq ft annually. An owner-occupied space of 5,000 sq ft would be valued using:

Valuation Impact Example:

If the property’s existing lease generates $120,000 in annual income, the appraiser may reduce the valuation to reflect the income shortfall relative to market rent.

D. Market Rent vs. Contract Rent – Risk Considerations

Example Scenarios:

A tenant pays $3,000/month in a lease signed during a market peak. Current market rent is $2,400/month. If the tenant vacates, the owner may struggle to replace the income.
A family Member leases space at above-market rent to inflate property income for a sale. This non-arm’s-length transaction may misrepresent actual market value.

E. Escalation Income

Definition: Additional income from lease clauses that pass-through increases in operating costs to tenants.

Example:
A retail lease includes a clause requiring tenants to pay their share of property tax increases. If taxes rise by $10,000 and the tenant’s share is 25%, the escalation income is:

F. Other Income

Definition: Income from sources other than base rent.

Examples:

· Space Rentals:

o Parking: 10 spaces rented at $100/month = $1,000/month or $12,000/year

o Storage units: 5 units at $75/month = $375/month or $4,500/year

· Equipment Rentals:

o Tenants pay $50/month for upgraded HVAC systems = $600/year per unit

· Concessions:

o Coin laundry generates $300/month. If operated by a concessionaire with a 50/50 revenue split, the owner receives $150/month or $1,800/year.

· Utility Resale:

o Owner buys electricity at $0.10/kWh and charges tenants $0.15/kWh. If tenants use 100,000 kWh/year, gross income is $15,000. Net income after cost is:

Income Stream Formulas

1. Potential Gross Income (PGI)

Represents the total income a property could generate if fully leased at market rent.

Formula:
Or, for mixed-use properties:

2. Contract Rent Income

Income based on existing lease agreements, adjusted for concessions.

Formula:

Where concessions may include:

Free rent periods
Tenant improvement allowances
Discounted escalation clauses
Other provisions in the lease, like a go-dark provision, or if the center becomes 50% or more vacant, then the master tenant can vacate.

3. Market Rent Income

Estimated rent for vacant or owner-occupied space based on comparable market data.

Formula:

4. Escalation Income

Additional income from lease clauses that pass through operating cost increases.

Formula:

Example:

5. Other Income

Ancillary income from non-rent sources such as parking, vending, laundry, or utility resale.

Formula:

Examples include:

Parking:
Laundry:
Utilities:

6. Effective Gross Income (EGI)

The actual income expected after accounting for vacancy and collection losses.

Formula:

Or:

Here are examples using each of the income stream formulas from Chapter I, Section II. These are designed to illustrate how the formulas work in practical underwriting scenarios:

Income Stream Formula Examples

1. Potential Gross Income (PGI)

Calculation:

Explanation: This total annual income assumes full occupancy at market rent, illustrating how potential gross income impacts underwriting decisions in real scenarios.

2. Contract Rent Income

Scenario: A retail center has five tenants. Each pays $5,000/month, but two tenants receive 2 months of free rent as a concession.

Calculation:

Gross annual rent:
Concessions:
Contract Rent Income:

Explanation: Contract rent reflects actual lease terms, adjusted for concessions.

3. Market Rent Income

Scenario: A vacant 3,000 sq ft office space has a market rent of $2.50/sq ft/month.

Calculation:

Explanation: This is the estimated annual income if the space were leased at current market rates.

4. Escalation Income

Scenario: A lease includes a clause where tenants pay their share of property tax increases. The total increase is $12,000, and a tenant occupies 25% of the building.

Calculation:

Explanation: Escalation clauses help owners recover increased operating costs.

5. Other Income

Scenario: A multifamily property earns additional income from:

Parking: 10 spaces at $100/month
Laundry: $4,800/year net
Vending: $1,200/year net

Calculation:

Parking
Total Other Income:

Explanation: These ancillary sources contribute to the property’s total income.

6. Effective Gross Income (EGI)

Scenario:

PGI = $432,000
Other Income = $18,000
Vacancy & Collection Loss = 8%

Calculation

Explanation: EGI reflects the actual income expected after accounting for vacancies and collection issues.

Case Study: Underwriting a Mixed-Use Income Property

Property Overview:
A mixed-use building in Orange County, California, contains:

10 residential units (each 900 sq ft)
2 retail storefronts (each 1,500 sq ft)
8 parking spaces
Coin-operated laundry and vending machines

Step 1: Calculate Potential Gross Income (PGI)

Residential Units:
Retail Units:
Total PGI:

Step 2: Adjust for Contract Rent

One retail tenant has a lease at $2.00/sq ft with 2 months free rent.

Adjusted Contract Rent:
The second retail unit is vacant and will be estimated at market rent.

Step 3: Estimate Market Rent for Vacant Space

Vacant retail unit:

Step 4: Calculate Escalation Income

Property taxes increased by $8,000. Each retail tenant pays 50%.

Step 5: Calculate Other Income

Parking:
Laundry:
Net income = $3,600
Vending:
Net income = $1,200
Total Other Income:

Step 6: Calculate Effective Gross Income (EGI)

PGI + Other Income:
Vacancy & Collection Loss (7%):
EGI:

Conclusion

A clear explanation of how to calculate Net Operating Income (NOI), building directly on the previous examples:

Calculating Net Operating Income (NOI)

Formula

Example: Continuing the Mixed-Use Property Case Study

From the previous case study, we calculated:

EGI = $320,292
Operating Expenses = $110,000 (includes property taxes, insurance, maintenance, utilities, management fees, etc.)

Calculation:

Explanation:

EGI accounts for all income sources (rent, other income) minus vacancy and collection losses.
Operating Expenses include all costs necessary to operate and maintain the property, but exclude debt service (loan payments), depreciation, and capital expenditures.
NOI reflects the property’s ability to generate income from operations alone and is used to:

· Evaluate investment performance

· Calculate the capitalization rate (Cap Rate): Cap rate = / Property Value

· Determine maximum loan amounts based on lender-required Debt Service Coverage Ratio (DSCR): DSCR + NOI / Annual Debt Service

Here is a short quiz on Net Operating Income (NOI) calculation, designed to test understanding of the concept and its application in income property underwriting:

Quiz: Net Operating Income (NOI)

Question 1

A property has an Effective Gross Income (EGI) of $500,000 and operating expenses of $180,000. What is the Net Operating Income?

A) $320,000
B) $680,000
C) $500,000
D) $180,000

Question 2

Which of the following is excluded from operating expenses when calculating NOI?

A) Property management fees
B) Utilities
C) Debt service (loan payments)
D) Repairs and maintenance

Question 3

A property has a PGI of $600,000, Other Income of $40,000, and a vacancy rate of 10%. Operating expenses total $200,000. What is the NOI?

A) $340,000
B) $380,000
C) $400,000
D) $420,000

Question 4

Why is NOI important in income property underwriting?

Question 5

A lender requires a minimum DSCR of 1.25. If a property has an NOI of $250,000, what is the maximum allowable annual debt service?

A) $200,000
B) $312,500
C) $250,000
D) $180,000

Here’s the answer key with explanations for the NOI Calculation Quiz:

Answer Key: Net Operating Income (NOI) Quiz

Question 1

EGI = $500,000, Operating Expenses = $180,000

NOI = EGI - Operating Expenses

✅ Correct Answer: A

Explanation: NOI is calculated by subtracting operating expenses from adequate gross income. It reflects the income generated before financing costs.

Question 2

Which is excluded from operating expenses?

✅ Correct Answer: C) Debt service (loan payments)

Question 3

PGI = $600,000, Other Income = $40,000, Vacancy Rate = 10%, Operating Expenses = $200,000

Step 1: Calculate EGI

Step 2: Calculate NOI

✅ Correct Answer: B

Explanation: EGI accounts for vacancy loss. NOI is the amount remaining after operating expenses are deducted.

Question 4

Why is NOI important?

✅ Correct Answer: B) It reflects the property’s profitability before financing costs

Explanation: NOI is a core metric in underwriting and valuation. It shows how much income the property generates from operations alone, independent of financing structure.

Question 5

NOI = $250,000, Required DSCR = 1.25

Formula: Maximum Debt Service = NOI / DSCR + 250,000 / 1.25 = $200,000

✅ Correct Answer: A

Explanation: To meet a DSCR of 1.25, the annual debt service must not exceed $200,000. This ensures the property generates enough income to cover debt obligations with a safety margin.

Introduction to Income Property Lender Practices and Underwriting

Chapter I, Section II:

Terminology and Application Relating to Income Stream.

Examples added for each key term to illustrate their practical application in underwriting and valuation, making the information more relevant and applicable to your work:

A. Potential Gross Income (PGI), Scheduled Gross Income, or Proforma Income

Definition: These terms refer to the total income a property is expected to generate if fully occupied at market rents, before deducting any operating expenses.

Example:

B. Contract Rent

Definition: The actual rent specified in current leases. It may differ from market rent due to negotiated terms.

Example:

A tenant signed a 5-year lease at $1,800/month two years ago. Market rent is now $2,100/month. The contract rent is still $1,800/month, which is below market.

Adjustment Example:

If the lease includes 2 months of free rent at the start, the effective contract rent over the first year is:

C. Market Rent

Definition: The rent of a property could command in the open market under current conditions.

Example:

A comparable office space in the same submarket leases for $30/sq ft annually. An owner-occupied space of 5,000 sq ft would be valued using:

Valuation Impact Example:

If the property’s existing lease generates $120,000 in annual income, the appraiser may reduce the valuation to reflect the income shortfall relative to market rent.

D. Market Rent vs. Contract Rent – Risk Considerations

Example Scenarios:

A tenant pays $3,000/month in a lease signed during a market peak. Current market rent is $2,400/month. If the tenant vacates, the owner may struggle to replace the income.
A family Member leases space at above-market rent to inflate property income for a sale. This non-arm’s-length transaction may misrepresent actual market value.

E. Escalation Income

Definition: Additional income from lease clauses that pass-through increases in operating costs to tenants.

Example:
A retail lease includes a clause requiring tenants to pay their share of property tax increases. If taxes rise by $10,000 and the tenant’s share is 25%, the escalation income is:

F. Other Income

Definition: Income from sources other than base rent.

Examples:

· Space Rentals:

o Parking: 10 spaces rented at $100/month = $1,000/month or $12,000/year

o Storage units: 5 units at $75/month = $375/month or $4,500/year

· Equipment Rentals:

o Tenants pay $50/month for upgraded HVAC systems = $600/year per unit

· Concessions:

o Coin laundry generates $300/month. If operated by a concessionaire with a 50/50 revenue split, the owner receives $150/month or $1,800/year.

· Utility Resale:

o Owner buys electricity at $0.10/kWh and charges tenants $0.15/kWh. If tenants use 100,000 kWh/year, gross income is $15,000. Net income after cost is:

Income Stream Formulas

1. Potential Gross Income (PGI)

Represents the total income a property could generate if fully leased at market rent.

Formula:
Or, for mixed-use properties:

2. Contract Rent Income

Income based on existing lease agreements, adjusted for concessions.

Formula:

Where concessions may include:

Free rent periods
Tenant improvement allowances
Discounted escalation clauses
Other provisions in the lease, like a go-dark provision, or if the center becomes 50% or more vacant, then the master tenant can vacate.

3. Market Rent Income

Estimated rent for vacant or owner-occupied space based on comparable market data.

Formula:

4. Escalation Income

Additional income from lease clauses that pass through operating cost increases.

Formula:

Example:

5. Other Income

Ancillary income from non-rent sources such as parking, vending, laundry, or utility resale.

Formula:

Examples include:

Parking:
Laundry:
Utilities:

6. Effective Gross Income (EGI)

The actual income expected after accounting for vacancy and collection losses.

Formula:

Or:

Here are examples using each of the income stream formulas from Chapter I, Section II. These are designed to illustrate how the formulas work in practical underwriting scenarios:

Income Stream Formula Examples

1. Potential Gross Income (PGI)

Calculation:

Explanation: This total annual income assumes full occupancy at market rent, illustrating how potential gross income impacts underwriting decisions in real scenarios.

2. Contract Rent Income

Scenario: A retail center has five tenants. Each pays $5,000/month, but two tenants receive 2 months of free rent as a concession.

Calculation:

Gross annual rent:
Concessions:
Contract Rent Income:

Explanation: Contract rent reflects actual lease terms, adjusted for concessions.

3. Market Rent Income

Scenario: A vacant 3,000 sq ft office space has a market rent of $2.50/sq ft/month.

Calculation:

Explanation: This is the estimated annual income if the space were leased at current market rates.

4. Escalation Income

Scenario: A lease includes a clause where tenants pay their share of property tax increases. The total increase is $12,000, and a tenant occupies 25% of the building.

Calculation:

Explanation: Escalation clauses help owners recover increased operating costs.

5. Other Income

Scenario: A multifamily property earns additional income from:

Parking: 10 spaces at $100/month
Laundry: $4,800/year net
Vending: $1,200/year net

Calculation:

Parking
Total Other Income:

Explanation: These ancillary sources contribute to the property’s total income.

6. Effective Gross Income (EGI)

Scenario:

PGI = $432,000
Other Income = $18,000
Vacancy & Collection Loss = 8%

Calculation

Explanation: EGI reflects the actual income expected after accounting for vacancies and collection issues.

Case Study: Underwriting a Mixed-Use Income Property

Property Overview:
A mixed-use building in Orange County, California, contains:

10 residential units (each 900 sq ft)
2 retail storefronts (each 1,500 sq ft)
8 parking spaces
Coin-operated laundry and vending machines

Step 1: Calculate Potential Gross Income (PGI)

Residential Units:
Retail Units:
Total PGI:

Step 2: Adjust for Contract Rent

One retail tenant has a lease at $2.00/sq ft with 2 months free rent.

Adjusted Contract Rent:
The second retail unit is vacant and will be estimated at market rent.

Step 3: Estimate Market Rent for Vacant Space

Vacant retail unit:

Step 4: Calculate Escalation Income

Property taxes increased by $8,000. Each retail tenant pays 50%.

Step 5: Calculate Other Income

Parking:
Laundry:
Net income = $3,600
Vending:
Net income = $1,200
Total Other Income:

Step 6: Calculate Effective Gross Income (EGI)

PGI + Other Income:
Vacancy & Collection Loss (7%):
EGI:

Conclusion

A clear explanation of how to calculate Net Operating Income (NOI), building directly on the previous examples:

Calculating Net Operating Income (NOI)

Formula

Example: Continuing the Mixed-Use Property Case Study

From the previous case study, we calculated:

EGI = $320,292
Operating Expenses = $110,000 (includes property taxes, insurance, maintenance, utilities, management fees, etc.)

Calculation:

Explanation:

EGI accounts for all income sources (rent, other income) minus vacancy and collection losses.
Operating Expenses include all costs necessary to operate and maintain the property, but exclude debt service (loan payments), depreciation, and capital expenditures.
NOI reflects the property’s ability to generate income from operations alone and is used to:

· Evaluate investment performance

· Calculate the capitalization rate (Cap Rate): Cap rate = / Property Value

· Determine maximum loan amounts based on lender-required Debt Service Coverage Ratio (DSCR): DSCR + NOI / Annual Debt Service

Here is a short quiz on Net Operating Income (NOI) calculation, designed to test understanding of the concept and its application in income property underwriting:

Quiz: Net Operating Income (NOI)

Question 1

A property has an Effective Gross Income (EGI) of $500,000 and operating expenses of $180,000. What is the Net Operating Income?

A) $320,000
B) $680,000
C) $500,000
D) $180,000

Question 2

Which of the following is excluded from operating expenses when calculating NOI?

A) Property management fees
B) Utilities
C) Debt service (loan payments)
D) Repairs and maintenance

Question 3

A property has a PGI of $600,000, Other Income of $40,000, and a vacancy rate of 10%. Operating expenses total $200,000. What is the NOI?

A) $340,000
B) $380,000
C) $400,000
D) $420,000

Question 4

Why is NOI important in income property underwriting?

Question 5

A lender requires a minimum DSCR of 1.25. If a property has an NOI of $250,000, what is the maximum allowable annual debt service?

A) $200,000
B) $312,500
C) $250,000
D) $180,000

Here’s the answer key with explanations for the NOI Calculation Quiz:

Answer Key: Net Operating Income (NOI) Quiz

Question 1

EGI = $500,000, Operating Expenses = $180,000

NOI = EGI - Operating Expenses

✅ Correct Answer: A

Explanation: NOI is calculated by subtracting operating expenses from adequate gross income. It reflects the income generated before financing costs.

Question 2

Which is excluded from operating expenses?

✅ Correct Answer: C) Debt service (loan payments)

Question 3

PGI = $600,000, Other Income = $40,000, Vacancy Rate = 10%, Operating Expenses = $200,000

Step 1: Calculate EGI

Step 2: Calculate NOI

✅ Correct Answer: B

Explanation: EGI accounts for vacancy loss. NOI is the amount remaining after operating expenses are deducted.

Question 4

Why is NOI important?

✅ Correct Answer: B) It reflects the property’s profitability before financing costs

Explanation: NOI is a core metric in underwriting and valuation. It shows how much income the property generates from operations alone, independent of financing structure.

Question 5

NOI = $250,000, Required DSCR = 1.25

Formula: Maximum Debt Service = NOI / DSCR + 250,000 / 1.25 = $200,000

✅ Correct Answer: A

Explanation: To meet a DSCR of 1.25, the annual debt service must not exceed $200,000. This ensures the property generates enough income to cover debt obligations with a safety margin.

Formula: Maximum Debt Service = NOI / DSCR + 250,000 / 1.25 = $200,000

✅ Correct Answer: A

Explanation: To meet a DSCR of 1.25, the annual debt service must not exceed $200,000. This ensures the property generates enough income to cover debt obligations with a safety margin.

Dan J. Harkey

Master Educator | Business & Finance Consultant | Mentor

Introduction to Income Property Lender Practices and Underwriting: Chapter I, Section II

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