Can someone break down to me the significace of the loan constant and cap rate to determine deal feasibility? My managing principal seems to use this method as back of the napkin underwriting. However, he just brought me a debt quote with a constant of 7.8% on a going in cap rate of 6.8%. I always thought the cap rate had to be higher than the constant? Wouldn’t this be negative leverage?
Thanks for the guidance.
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Loan constant is loan payment divided loan amount. $500,000 loan with a 5% interest rate = $32,209.32 in payment per year (assuming a 30 year amortizing loan). This is a 6.44 loan constant. If it’s a total purchase price of $1,000,000 at a 6% cap rate, that’s $60,000 in NOI. The deal is still cash flowing positively (assuming no capex payments which might make it negative) even though the loan constant is higher than the cap rate.
So why is there such weight on the spread between constant and cap rate when it still cash flows?
Why not use DSCR? It would take difference between NOI and debt payment into account.
It does more or less the same thing. Loan Constant is just an alternative measure which can be used for a myriad of different things. Loan Constant better shows how the amortization is affecting your cash flows which can be used to compare loan quotes. For example, if you have a quote at 5% 10/25 (Quote A) and a quote at 5.25% full term I/O (Quote B), the Loan Constant for Quote A is 7.02% while the loan constant for Quote B is simply 5.25%. If you were purchasing a property at a 6% cap rate, your return on equity (in year 1) would be lower than the cap rate with Quote A and greater than the cap rate with Quote B.
This metric matters on stabilized NOI. If this is a value add play (or if in place rent is below market) then that’s probably why he’s ok even if the loan constant is higher than in place NOI. Also it becomes a little more complicated with amortization. Most developments would have negative leverage with amortization but appear to have positive leverage because of the I/O.
Kind of related, but get to understand your sources of debt and how they size their covenants and their loans. Banks test on a stressed basis, so you could be paying Libor of 2.5% + 1.5% spread for a deal but your covenants are tested on a 6.0%/30-yr basis, which would be a constant of 7.2% and the lender would size the loan on top of that constant; for example, a 1.20x sizing would be 7.2*1.2 or 8.64% DY.
Once you have LTC you can use the 3 inputs to solve for levered yield. You can also make rough % assumptions for capex, cap rate expansion/compression and growth to solve for a rough Unlevered and levered IRR. All of this assumes a stabilized project of course
Can you go through that calculation from LTC to levered yield?
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