CRE Loan Terms

I. CAPITALIZATION RATE
Those who invest in real estate via income-producing properties need to have a method to determine the value of a property they’re considering buying. By using other properties’ operating income and recent sold prices, the capitalization rate is determined and then applied to the property in question to determine current value based on income.

  • Get the recent sold price of an income property, such as a strip mall or apartment complex.
  • Determine the net operating income, or the net rentals realized by the owners. Example: The rental income after expenses (net) for a recent request is $259,421.
  • Divide the NOI by Sales Price to get Cap Rate.
  • Example: $259,421 / $3,550,000 = .073 or 7.3% (The Capitalization Rate)

Intuition Behind the Cap Rate
What is the cap rate actually telling you? One way to think about the cap rate intuitively is that it represents the percentage return an investor would receive on an all cash purchase. In the above example, assuming the real estate proforma is accurate, an all cash investment of $3,550,000 would produce an annual return on investment of 7.3%. Another way to think about the cap rate is that it’s just the inverse of the price/earnings multiple.

Consider the following chart:

cap_rate_multiple

As shown above, cap rates and price/earnings multiples are inversely related. In other words, as the cap rate goes up, the valuation multiple goes down.

When, and When Not, to Use a Cap Rate
The cap rate is a very common and useful ratio in the commercial real estate industry and it can be helpful in several scenarios. For example, it can and often is used to quickly size up an acquisition relative to other potential investment properties. A 5% cap rate acquisition versus a 10% cap rate acquisition for a similar property in a similar location should immediately tell you that one property has a higher risk premium than the other.

Another way cap rates can be helpful is when they form a trend. If you’re looking at cap rate trends over the past few years in a particular sub-market then the trend can give you an indication of where that market is headed. For instance, if cap rates are compressing that means values are being bid up and a market is heating up. Where are values likely to go next year? Looking at historical cap rate data can quickly give you insight into the direction of valuations.

While cap rates are useful for quick back of the envelope calculations, it is important to note when cap rates should not be used. When properly applied to a stabilized Net Operating Income (NOI) projection, the simple cap rate can produce a valuation approximately equal to what could be generated using a more complex discounted cash flow (DCF) analysis. However, if the property’s net operating income stream is complex and irregular, with substantial variations in cash flow, only a full discounted cash flow analysis will yield a credible and reliable valuation.

II. DEBT YIELD

Debt yield ratio is a method used to determine the maximum amount of commercial real estate loans. It is the Net Operating Income (NOI) as a percentage of the total loan amount (first mortgage). Referencing the same example, a commercial property with a NOI of $259,421 per year and a proposed loan amount of $2,485,000.

  • Example: $2,485,000 / $259,421 = 10.4% (Debt Yield)

Most lenders establish ten percent as a minimum debt yield ratio.  Higher ratios reduce the risk that the developer will default on a mortgage payment. Different lenders set different minimum debt yields, and the required yield can vary when interest rates rise or fall.

So while NOI is used in both calculations loan amount takes the place of debt service when we are calculating debt yield. Loan amount is a straight forward number and not as subject to interpretation as debt service which makes debt yield a very solid and easy to calculate ratio.

III. DEBT SERVICE COVERAGE RATIO

Debt Service Coverage Rato (‘DSCR’), in general terms, refers to the property’s ability to generate sufficient income to cover payments related to its debt.  Another method used to determine the maximum amount of commercial real estate loans, it is the Annual Net Operating Income (NOI) divided by the Annual Total Debt Service Requirement.

Debt-Service Coverage Ratio (DSCR)

Referencing an different example, an industrial property with a NOI of $288,620 per year and a proposed loan amount of $3,000,000.

  • Example: $288,620/$187,052 ($3,000,000 @ 3.85% Interest Rate @ 25 Years) = 1.54x

A lender will establish a minimum DSCR policy that a property must meet to be applicable for a loan.

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