Analyzing a Commercial Mortgage Loan - Capitalization Rates

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After we have determined an NOI that we are comfortable with, the next item that we will use in the process of analyzing a commercial mortgage loan,

After we have determined an NOI that we are comfortable with, the next item that we will use in the process of analyzing a commercial mortgage loan, is a term that you probably have heard but maybe not completely understood. This is the capitalization rate or the cap rate of an investment. Simply put, this number represents the return that a buyer of a commercial property is looking to earn on his or her investment, and is also used in the process of trying to place a price on a building for a seller. Needless to say, the cap rate is not an exact science, and depending on whether you are the buyer or the seller of a building, can definitely vary.

Capitalization Rate DSCR Loan

Let's say as a buyer of an income producing property, you would like to earn as high a return on your investment as is possible, at a given level of risk. Every city, town and even area within a town will have a cap rate associated with it. Depending on a variety of factors that includes the quality of the area, type of building, quality of tenants, etc., an area will be analyzed at a certain cap rate. Cap rates are not static numbers, but can change over time as the nature of an area changes. A perfect example would be parts of Manhattan that have seen significant cap rate declines over the past 10 years as they have become gentrified.

Net Operating Income (NOI)/cap rate = Building value

Remember that this is a building value based on the cap rate that you put in. As an example, take a building that has an NOI of $80,000 per year, and it is in an area where the cap rate is approximately 7.5%. That is, a buyer in that area wants to earn a return on investment of 7.5%.

$80,000/.075 = $1,066,666

The higher the cap rate or return desired, the lower the value of the building and visa versa.

The mortgage rate on a commercial mortgage loan has to be below the cap rate for the deal to make sense.

If the cap rate in the example above were higher or lower, how would it affect the value of the building?

$80,000/.08 = $1,000,000

$80,000/.07 = $1,142,857

The buyer of a building wants to buy at the highest cap rate possible, and the seller at the lowest. The process of the negotiation of price must begin with a reasonable determination of cap rate for the building and for the area, and ends with some meeting of the minds between the buyer and the seller.

The next step in the process is going to be the most important, and that is going to be determining the debt service coverage, or DSCR, of the desired loan at a given interest rate and NOI that we calculate.

 

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