This is the third article in my series on cap rates and commercial mortgage finance. My eventual goal is to explain a line from an earlier blog article, where I pointed out:
"If the interest rate on a commercial loan is 13.9% and the commercial property is valued based on an 8% cap rate, it is mathematically impossible for the property to carry a new commercial loan larger than 57% loan-to-value."
Please stick with me here. The math sounds hard, but its really not. You are going to learn a TON today about cap rates, commercial loan constants, and commercial real estate valuation. Let's start with a little review.
In prior articles, we said that a Cap Rate was merely the return on your money (think of it like the "interest rate" you would earn) if you bought a commercial property for all cash. Cap rates can vary from 3.5% to 13%, but an average commercial property in an average area these days sells at a cap rate of between 8% and 9.75%.
For example, let's suppose you win the lottery, but its only a small one. You net $1 million after taxes. You're 63 years old, you've been brokering commercial loans for 25 years, and you're tired. You're ready to retire and live off your investments.
Your local bank is only paying 1% on C.D.s, so if you left your $1 million in your local bank, you would only earn $10,000 per year in interest. You can't retire on social security and a lousy $10,000 per year in interest. You need a better return on your money.
You decide instead to buy a little 4-unit strip center, not far from your house, that houses a convenience store, a real estate office, a hair salon, and a chiropractor's office. You pay $1 million for the strip center, and you buy it at an 8% cap rate. This means that you would enjoy $80,000 per year in net rental income (8% of $1 million), which is enough, taken together with your social security, to retire. Please note that the 8% return is a MUCH better deal than the 1% return offered by your bank.
Now let's talk about commercial loan constants. When I first started in mortgage finance 36 years ago, the typical mainframe computer was the size of a small home. It would take a mainframe computer a full two hours to compute the monthly payment on a $25,000 loan at a 4.25% interest rate, fully-amortized over 30 years. Obviously a loan agent couldn't carry a ten-ton mainfame computer on his back when he went out to someone's home to take a loan application; but the borrowers still wanted to know what their monthly payments would be. Therefore the commercial loan constant was created.
A loan constant is merely the monthly payment on a loan of exactly $1,000, fully-amortized over 30 years.
For example, the loan constant at 4.25% is $4.90 per month. In other words, if you borrowed exactly $1,000 at 4.25% interest, and if you made $4.90 per month payments for 30 years, your $1,000 loan would be completely paid off. See, that wasn't so hard, was it?
Now the year is 1977, and I am on my way to take a loan application on a residential borrower at his home. Instead of lugging a ten-ton computer on my back, I just bring my trusty loan constant ($4.90 per month). When the borrower decides to borrow $25,000 and asks for his monthly payment, I simply multiply my trusty loan constant of $4.90 by the number of thousands that he wants to borrow, in this case 25. The answer is $122.50 per month. That's the monthly payment on a loan of $25,000, fully-amortized over 30 years at 4.25%.
"But gee, George, what if the interest rate changes? Won't the loan constant change?"
Yes it will. Suppose the interest rate drops to 4.125%. Home office will have to warm up old Ten-Ton-Betty (the company's mainframe computer) and have her devote two hours to computing the new loan constant. In the morning, the office manager will inform us of the new loan constant. We each received a stone tablet into which the new loan constant was chiseled. (Just kidding!)
Now over time the term "loan constant" has evolved. Nowadays the loan constant represents the interest rate you used when you computed the debt service coverage ratio.
For example, you might call up your favorite bank commercial loan officer and say, "Bob, I have a great commercial loan for you. The debt service coverage ratio is a whopping 1.55 based on a 3.75%, 30-year constant."
At which point Bob replies, "Gee, George, that all sounds great and everything, but because of the age of your commercial property, Loan Committee is going to want to amortize our loan over just 20 years. And unfortunately our interest rate is not 3.75%. It's 6.125%. As I calaculate your deal, the debt service coverage ratio is just 1.07 based on a 6.125%, 20-year constant. Your deal doesn't qualify. Our minimum debt service coverage ratio is 1.25."
This is why veteran commercial mortgage brokers always disclose the loan constant they used when they computed the debt service coverage ratio.
This review having now been completed, in my next blog article I will show you why a property valued based on an 8.0% cap rate mathematically cannot carry any 13.9% loan higher than 57% loan-to-value.