Analyzing a Commercial Mortgage Loan - Capitalization Rates

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

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.

Analyzing a Commercial Mortgage Loan - Net Operating Income

In my previous article we touched on the basic criteria that make a commercial mortgage loan a much different animal from a residential mortgage loan. In a nutshell, it is the fact that whatever loan amount is desired for an income producing property must be supported by the income that the given building produces. This leads us to the first most important calculation:

Net Operating Income

When you are speaking to a potential borrower, one of the first, if not the first thing that you will ask is (after or at the same time as credit score): Do you know what the net operating income of the building is? Simply, the net operating income, or NOI, is the gross rents of the building minus the operating expenses of the building. Because the NOI of the building has to be able to support the desired loan, it is imperative to get to a very accurate number. This means that we don't necessarily rely on what the borrower is telling us, but look for verification. This is important because any "inaccuracies" will come out during the due diligence process, so once again we do not want to waste our time on a deal that cannot be done. If actual expenses are higher than what we are being told, or actual rents are lower, this can turn what at first glance looked like a great deal into a deal that cannot be funded. A little legwork early in the process can save you a lot of time and effort later, as well as the experience of a deal "crapping out" late in the process.

What goes into the NOI calculation? We need the following:

Gross rents

Expenses

Property Taxes
Building insurance
Utilities

10% of the gross rents to account for management and vacancy

NOI = Gross rents - expenses

Very simple calculation. For verification of expenses, you can use PropertyShark.com for taxes or the assessor's office, and for utilities and insurance ask to see recent bills. As far as rents go, have an idea of what market rents in a given area should be, and ask for current leases. Once again, do not try and manipulate numbers to make a deal that won't work suddenly work. In this business your relationship with a lender is more important than a single deal, and trying to fudge numbers is the best way to lose that relationship. Realize as well, that everything will come out in the wash, or as we call it the due diligence process.