You're considering the purchase of an industrial warehouse. The purchase price is $1 million. You expect to hold the property for five years. You've decided to finance the acquisition with the $700,000 loan, 10 percent interest rate, 30-year term, and annual interest-only payments. (That is, the annual payment will not include any amortization of principal.) There are no up-front financing costs. You estimate the following cash flows for the first year of operations:
$135,000 Effective gross income
27,000 Operating expenses
$108,000 NOI
a. Calculate the overall rate of return (or "cap rate").
b. Calculate the debt coverage ratio.
c. What is the largest loan that you can obtain (holding the other terms constant) if the lender requires a debt service coverage ratio of at least 1.2?