Frequently Asked Questions

What is a Capitalization Rate (Cap Rate)

The "cap rate" is used by informed real estate investors to estimate the value of an income producing property. It shows the productivity of an income producing property.

The cap rate is the ratio used to estimate the value of income produced by the property. The cap rate is the net operating income divided by the sales price of the property. If you look at a typical commercial real estate transaction, the seller of a property is trying to sell for the highest price and the lowest cap rate, the buyer is trying to buy the property at the lowest price which translates into a higher cap rate. The lower the sales price the higher the cap rate. Market cap rates vary from marketplace to marketplace and can vary depending on the motivation of the seller and the eagerness of the buyer.

How Calculated: The cap rate is the relationship between Net Operating Income and the value of the income producing property. The Net Operating Income of recently sold income property is compared to their sale price.

Components: 1. The Net Operating Income is the amount of cash that a property is capable of generating annually if owned free and clear of debt, and before income tax payments. 2. The sale price is the price paid by an informed investor for the right to receive that amount of Net Operating Income in the future.

Calculation: Divided the Net Operating Income by the sale price. The resulting number is the "cap" or "capitalization" rate.

What Do I Need to Know About Cap Rates?

1. Cap rates vary with each type of income property will usually have a unique and similar cap rate (apartment complexes vs office buildings vs medical buildings vs retail buildings – each property type will have a different cap rate)

2. Cap rates vary with each market and submarket. The cap rate for an apartment complex in Seattle will vary from the cap rate of a very similar apartment complex in San Francisco or Eugene, Oregon. The perceived risk inherent in each market and each submarket will influence the cap rate of highly similar property types.

3. If you carefully study the typical commercial real estate transaction, you will find that the seller is trying to sell for the highest price (which will produce a low cap rate); and, the buyer is trying to buy the property at the lowest price (which translates into a higher cap rate for the available income stream). For the same income stream to the investor, the lower the sales price, the higher will be the cap rate.

4. Market cap rates can vary with the level of motivation of the seller and the eagerness of the buyer.

Where Can I Find a Reasonable Cap Rate?

1. Call a local real estate appraiser who is very experienced in appraising the type of income property that you seek to buy or sell. Ask for a range of reasonable cap rates for that specific type of property.

2. Call a real estate investment broker who is dominant in the market area which interest you, and who is most experienced with brokering transactions for your specific type of property.

What is a Debt Coverage Ratio (DCR)?

The Debt Coverage Ratio or DCR is the lender's primary way of generating lender safety when making a loan on an income property. The DCR will specifically calculate the maximum amount of loan that the lender should make for any given income stream.

Debt coverage ratio measures the property's ability to cover the monthly debt load from the cash generated from the property. Lenders use this formula to determine if the property will generate enough cash to cover the loan amount requested plus the other monthly rental expenses (property manager fee, water, sewer, etc).

Why Lenders Think This Way: All lenders are absolutely aware of the risk of lending too much money on a property. If the lender is the only one with "skin in the game" the borrower may find it both easy and convenient to simply hand a bag of keys to the lender and given them the tenant rent roll, and walk off from a property that is generating too much negative cash flow.

In order to assure that an income property can safely service the monthly payments, the lender makes a loan that forces the property to generate a positive cash flow. "Never lend so much money that there will be negative cash flow"… the mantra of the commercial mortgage lender.

What Debt Coverage Ratio do Lenders Require?

A debt coverage ratio of less than 1 means there is not enough cash flow to pay back a mortgage loan. Most lenders are looking for a coverage of 1.35 which means the property will need to generate 1.35 or (35% more) in cash above and beyond what is required to pay the monthly mortgage payment.

How is the DCR Is Applied?

1. Determine a conservative estimate of the property's Net Operating Income

Example: NOI = $150,000 per year

2. Divide the Net Operating Income by the lender's selected DCR (e.g. 1.30)

Example: $150,000 / 1.30 = $115,385 in annual debt service (PI only)

3. Divide the annual debt service to determine allowed monthly debt service

Example: $115,384 / 12 = $9,615 PI per month

4. Calculate the size of loan that would be amortized by the allowed monthly payment (use a present value calculator such as a HP10BII)

Example: if the interest rate is 6.5% and the allowed amortization term is 30 years, then the maximum sized loan that $9,615 per month would amortize is $1,424,000

The lender now knows that if the maximum allowed loan is $1,424,000 on a property that can safely generate $150,000 in annual NOI or $12,500 in monthly NOI, the investor will receive the "left-overs" after making the mortgage payment.

Restated (Investor's View): $12,500 in monthly NOI – $9,615 in monthly payment = $2,885 in monthly cash flow to the investor.

Restated (Lender's View): The property would have to slip at least $2,885 in lost income or increased expenses before the lender would fear a late payment or worst yet a missed payment. Force the investor to have positive cash flow, and you will have little chance of getting the property given back to the lender.

The "good old days" of low Debt Coverage Ratios is over! Lenders understand that there is no glory in foreclosing on a property, only to discover a visit from a bank auditor can force them to "mark the asset to market", thus forcing the lender to show a loss on their balance sheet

Contact us, and we will suggest several names of lenders who could give you hints on current Debt Coverage Ratios for the type of property that is of interest to you.