As a REALTOR specializing in investment real estate, a key fundamental is the cap rate, an easy-to-calculate ratio (net operating income divided by the purchase price) that indicates a rate of return. The cap rate assumes a cash deal, which it most likely isn’t. That said, cap rate is a good way to compare buildings before getting more deeply into weeds like how will a lender look at the deal. For those purposes a down-and-dirty cap rate won’t cut it. But the Gettel lender cap rate does.
Consider the following, completely unrealistic hypothetical situation.
- Asking price: $100,000
- Down payment: $25,000
- Gross annual income: $50,000
- Gross operating expenses: $45,000
- NOI: $5,000
- Cap rate: 5%
Here is what we take to the bank…
- we are putting down $25,000 (25%)
- we are borrowing $75,000 (75% LTV)
- the loan will be fully-amortized with a term of 25 years
- the interest rate is 4.50%.
When these numbers are plugged into a financial calculator or and Excel spread sheet, the annual debt service including principal and interest will calculate to $5,002. In other words, the net operating income (NOI) and the debt service are essentially equal to one another. That means every dollar that comes in goes to pay debt service…a debt service coverage ratio of 1.0. No bank will make this loan, and no buyer should want the deal.
At this point we have two choices: we can walk away from the deal or we can come up with some numbers that will make the deal work. Those numbers will emerge from a calculation known as the Gettel lender cap rate (see note below). The calculation hinges on the debt coverage ratio that the bank will likely require. In this case we are going to use a ratio of 1.25, which means that for every dollar of income that flows out to pay debt service, there is an additional .25 cents that the borrower can use to pay operating expenses. Note: in higher-risk economic environments lenders might require a higher ratio.
The result of the Gettel formula calculation is that a 6.25% rate of return (rather than 5%) will meet the bank-required 1.25% debt coverage ratio and throw off an income sufficient to cover monthly debt service AND normal operating expenses. The result is a better investment for both parties…the buyer and the bank.
The challenge, of course, is that in order to get that higher rate of return something has to give: either the acquisition price of the property has to go down…in this case to $79,960 from $100,000…or the deposit has to go up to $40,000. In both cases the debt coverage hurdle of 1.25 will be met.
Will the seller accept a deal at the lower price? And, if not, will you be willing to increase your cash deposit to $40,000?
And, to complicate matters, neither of these options exist in a vacuum. There is the matter of cash-on-cash return. If the seller agrees to reduce the price to $79,960 the cash-on-cash return is 5%. If you agree to increase your deposit to $40,000, the return drops to 2.5%. In either case is this deal the best use of your cash?
Make sure you have an agent who will work with you to uncover the answers.
Note: Unlike the typical cap rate, the Gettel formula considers the following variables: property cost, NOI, loan amount, equity, interest rate; term, mortgage constant, annual debt service, debt service coverage ratio.