Debt Constant Check Before Modeling
WSO,
Our group is working within the medical/traditional office space. I recently have heard that, prior to modeling out a potential deal, you can save a lot of time by just checking the debt constant. They claim that if the debt constant exceeds the cap rate the deal already won't work.
My question is, is this rigid criteria for someone who needs to meet a certain hurdle? How can you consider a seemingly good deal if the debt constant is above the cap?
Thank you all in advance for your advice.
It shows you will have positive or negative leverage. The latter obviously meaning the deal won’t pencil with leverage added (CoC % will be below your going in cap..)
As with everything, it depends. Are these stabilized deals or core+/value-add/opportunistic? If the latter, then I can guarantee that these days unless you are buying office or tertiary NNN deals, your going in cap rate will probably be less than your debt constant. If you are adding significant value and scaling NOI, then it’s more of a qualitative exercise as you need to understand when in your model you get to positive leverage as the NOI grows. For these deals especially, negotiating a meaningful interest only period will help your cash flow. But if your stabilized cap rate or YOC is less than your debt constant, then yes, that’s probably a non-starter unless you are betting on falling rates. Also, make sure to be careful and compare your untrended YOC/cap rate (I.e. with no rent growth) against your debt constant to make sure that you aren’t betting on a large amount of market rent growth to bail you out. This is a cyclical business and rents can go down and economic vacancy can go up. This is always an important stress test to evaluate, but not always as easy as looking at one ratio.
Just depends on strategy. The going-in cap rate doesn't tell you much for opportunistic and value-add deals, but it tells you quite a bit for core-plus and core. I'd be more focused on my stabilized untrended return on cost and how that compares to your mortgage constant. Most deals right now are negatively leveraged once amortization kicks in - and in some cases significantly so. That's how buying at a 5.75% cap rate generates you a 3-4% cash yield.
This - the back of napkin analysis works great for core/core plus deals where you're not going to see much NOI growth, but with value-add/opportunistic if you can increase NOI by 5-10% in a year or two then buying at negative leverage short-term isn't a big deal.
I work in medical and for build to core and core deals were more focused on positive leverage at reversion. Ie is spread + forward sofr in terminal month less than exit cap
It's been a while but yes these are stabilized assets. Very helpful comments guys.
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