Damages for Interfering With Your Real Property Rights. What’s It Worth?

When you’ve suffered damages to your real estate involving an income-producing property, it is sometimes difficult to determine exactly how much money you’ve lost. In fact, we often tend to under-estimate our losses by not considering how the timely payment of money goes to work for us. Today’s blog shows you some useful formulas for calculating the loss of income generated by an income-producing property — when somebody else is to blame.

Debt Service Coverage Ratio

The debt service coverage ratio (DSCR) answers the question: how much income is available to pay down debt after operating expenses have been paid. The formula explores the relationship between net operating income (NOI) and debt obligations. It actually produces a net income percentage, and the difference in that percentage from one point in time to another reflects a potential item of damages. The formula is NOI/Debt, where the debt consists of principal plus the interest, such as in the case of a mortgage payment.

For example, let’s say that Oscar has a rental property with an NOI of $50,000. He has mortgage payments (principal plus interest) totaling $39,800. Oscar’s debt service coverage ratio is 25.6%.

DSCR = NOI/Debt

DSCR = $50,000/$39,800

DSCR = 1.256

[1.256 – 1 = 0.256]

If Oscar’s mortgage debt were as high as his NOI ($50,000), his income-to-debt ratio would be 1 (or effectively, 1 to 1), meaning that his rental property would generate only enough money in income to cover its debt. In the example above, however, Oscar’s DSCR is 1.256, meaning that he is generating 25.6% more in income than he needs to cover his debt (to pay his mortgage).

Let’s now assume that the contamination of a water system by an industrial polluter prompts civil litigation over the adverse effects suffered by Oscar’s rental properties. One way to explore the damages Oscar suffered is to examine the difference in debt service coverage both before and after the adverse events occurred.

After the water system contamination, Oscar’s NOI may have dropped to $40,000. His DSCR now looks like this:

DSCR = NOI/Debt

DSCR = $40,000/$39,800

DSCR = 1.005

[1.005 – 1 = 0.005]

His revised DSCR is now just 0.5% — a significant drop from the 25.6% he enjoyed before the contamination occurred.

Or, let’s assume that Oscar’s NOI remains the same at $50,000, but that his special plumbing, piping, and water supply replacement costs rise significantly, raising his total recurring debt to $51,500. The DSCR ratio now produces a problematic result:

DSCR = NOI/Debt

DSCR = $50,000/$51,500

DSCR = 0.970

[0.970 – 1 = 0.03]

Now, Oscar is not generating enough income to meet his debt. In fact, he is negative 3%, that is 3% short. His damages, based on the pre-contamination DSCR of 25.6%, are nearly 29% (representing the difference between a positive 25.6% and a negative -3%).

Another approach to DSCR formula is to account for the tax rate in calculating debt. In this variation, NOI is treated as earnings before interest and taxes. Debt is treated as principal plus interest, but the principal is divided by the inverse of the tax rate (that is, 1 minus tax rate). The revised formula is:

DSCR = Operating Income (Earnings before interest and taxes) divided by [(Principal/1-Tax Rate) + Interest]

We’ll assume that the operating income is $100,00, and that the interest due is $20,000. The principal of $50,000 is divided by 1 minus the tax rate, which we’ll say is 33% in this case.

DSCR = $100,000 / [($50,000/1-0.33) + $20,000]

DSCR = $100,000/$74,626.87 +$20,000

DSCR = $100,000/$94,626.87

DSCR = 1.056

[1.056 – 1 = 0.056].

The DSCR is therefore 5.6% at a 33% tax rate.

Return on Investment

The basic formula for return on investment (ROI) can also be explored to gauge damages in a real estate action. ROI, in its simplest form, is stated as the gains minus the costs, divided by the costs:

ROI = Gains – Costs / Costs

This could be stated as income minus costs divided by costs:

ROI = Income – Costs / Costs

It is essentially the difference between the before-and-after ROIs that provides a snapshot of our damages in a given case.

Example: A mudslide occurs on a residential tract causing significant structural damage, attributable to negligent engineering, design, and construction work. Before the mudslide, the subject property generated $2.4 million in income at a cost of $800,000. After the mudslide, it generates $1.9 million in income at a cost of $950,000. Using the simplified formula for ROI, we can compare before-and-after scenarios:

BEFORE:

ROI = Income – Costs/ Costs

ROI = $2,400,000 – $800,000/ $800,000

ROI = 2

2 x 100% = 200%

Therefore, before the mudslide, there was a 200% return on investment.

AFTER:

ROI = Income – Costs/ Costs

ROI = $1,900,000 – $950,000/ $950,000

ROI = 1

1 x 100% = 100%

Therefore, after the mudslide, there was a 100% return on investment.

Another variation of the simplified ROI is to divide net profit by assets. In this approach, costs are deducted from the numerator to produce a single net profit amount. If, for example, net profit was stated at $85,000, and assets were valued at $225,00, the formula would look like this:

ROI = $85,000/$225,000 = 0.3777

ROI is therefore approximately 38%. Again, a before-and-after analysis can provide a useful snapshot of the damages suffered in a given case.

Another way to characterize the ROI formula is to treat the numerator as the NOI, which is roughly the equivalent of income minus costs or net profit. In this variation, we divide the NOI by the total investment:

ROI = NOI/Total Investment

Assume that an investor wishes to purchase a large income-producing property and, under current market conditions, can make the purchase for a down payment of $100,000. The sellers, however, did not relinquish the premises on a timely basis, and because of the delay, the investor lost the advantage of a lower interest rate, costing him an additional $10,000. Moreover, the sellers fraudulently concealed a construction defect which the investor was forced to repair at a cost of $33,000. Altogether, the investor’s total investment equals $143,000.

If the investor’s NOI was $17,500, then his ROI would be roughly 12%, calculated as follows:

ROI = NOI/Total Investment

ROI = $17,500/$143,000

ROI = 0.122

But what if the sellers had conveyed the property on a timely basis, so that the investor could obtain the lower interest rate? And what is the sellers had delivered a structurally sound property without a costly construction defect? The investor’s total investment would then be only $100,000, and the ROI formula would be 17.5% as follows:

ROI = $17,500/$100,000

ROI = 0.175

The difference between the originally projected ROI of 17.5% and the actual resulting ROI of 12.2% is 5.3%. In other words, the investor’s damages amount to a 5.3% reduction in his ROI.

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