A Different Way to Use a Capitalization (Cap) Rate

As a REALTOR specializing in investment real estate, the question that I hear most often is, What is the cap rate?

Experienced real estate investors know that a cap rate is a simple, down-and-dirty indicator as to whether a deal has potential. But, experienced investors also know that cap rate assumes a cash deal and that it likely does not include very real costs like vacancy allowances, maintenance and management fees. So, as part of my real estate practice I run my own numbers making sure to add those costs that might be omitted by the seller’s broker. In addition, I include another kind of cap rate in my analysis, this one assuming that my client will take on debt in order to complete the purchase. It is how a bank might look at the deal. Consider the following:

Contract price: $100,000
Down payment: $25,000
Revenue/year: $50,000
Expenses/year: $45,000
NOI: $5,000
Cap rate: 5%

Enter the bank. For a hypothetical loan of $75,000 (75% LTV) against this property, the bank will offer a fully-amortized loan, with a down payment 25%, an interest rate 4.50%, and a term of 25 years. The annual debt service including principal and interest will come to $5,002.

Two things to note about the numbers: a 5% cap rate, although common in low-risk markets like Montclair, might be disqualifying for more aggressive investors; and, all of the net operating income (NOI) of $5,000 is going toward paying the mortgage; every dollar that comes in goes out to pay debt service. In lender-speak, that is a debt coverage ratio of 1.0. No bank will make that loan, and no buyer should want the deal.

However, when the above numbers are put together with two additional ones…a bank-mandated debt coverage ratio of 1.25 and the mortgage constant…a new, higher cap rate pops out: 6.25%. Unlike the first cap rate, which suggests that the investment would return 5% in year one if the deal was all cash and the revenue and expense numbers were accurate, this one expresses what the cap needs to be for the bank to be minimally secure with its investment in the property. In other words, at a 6.25% cap the property owner will make a sufficient income to cover regular mortgage payments AND normal operating costs thereby making the property a better investment for both parties…the buyer and the bank. The kicker, of course, is that in order to get that higher rate of return something has to give and that’s the acquisition price of the property; it has to drop from $100,000 to $79,960 just to clear the 1.25 debt coverage hurdle. (A second option would be to increase the deposit from $25,000 to $40,000. Doing so, however, was not in the scope of this scenario.)

Will the seller accept a deal at the lower price? And, given the level of risk inherent in the property, will an investor be satisfied with a 6.25% cap? Important questions, for sure. Fortunately, there are some good tools to help answer them.

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