CAP rate, debt coverage ratio & loan to value
Capitalization (Cap) Ratio
One very popular and quick method of estimating a commercial property’s valuation is applying the specific market’s Cap Rate for the type of property using the following formula:
Cap Rate (%) = Annual Net Operating Income (NOI) / Purchase Price. As with any simple algebraic equation, if you know 2 of the numbers, it is very simple to determine the 3rd. The NOI (Net Operating Income) includes normalized operating revenues and expenses, but excludes depreciation, amortization, interest expenses and income taxes, as these are investors or owners specific and would lead to comparisons of apples to oranges etc..
Let’s use the example of a multi-unit residential building to illustrate the valuation process. Assume the apartment building has a normalized annual NOI of $150,000 and the current market cap rate of 5.5 %. Reconfiguring the above formula, the building’s estimated valuation is $150,000 / .055 = $2,727,273. Please note that cap rates vary over time and are specific to a location and the type of building generating the NOI.
Although the Cap Rate is the most popular listing or advertised data for commercial buildings, it does have a number of serious shortcomings as follows. Firstly, it assumes that the NOI continues at the same annual rate forever, and secondly, it ignores the future sale of the property. Finally, it does not include the individual investor’s financing and income tax positions, both of which are extremely important when analyzing any potential investment property. For these reasons, seasoned investors normally use the Cap Rate Method of Valuation simply to determine if a specific property merits spending more time doing an in-depth analysis, such as calculating the discounted Net Present Value and Specific Term Blended Internal Rate of Return
Debt Coverage Ratio for Commercial Mortgages
Unlike residential mortgages, where the individual is used to determine the approvability of mortgages, commercial mortgage lenders are primarily interested in the actual cash flow of the building, with the investor normally being reviewed secondarily.
One of two primary commercial loan criteria involved is called the Debt Coverage Ratio and is the inverse of the residential mortgage criteria known as the Debt Service Ratio. Another major difference is that the answer is expressed as an actual ratio as opposed to the residential formula’s answer which is usually presented as a percentage.
The Debt Coverage Ratio is defined as the number of times the annual Net Operating Income (NOI) covers the annual mortgage payments of principal and interest. The NOI (Net Operating Income) includes annual normalized operating revenues and expenses, but excludes depreciation, amortization, interest expenses and income taxes, as these are investor/owner specific and would lead to comparisons of apples to oranges etc..
The following example should provide clarity. A commercial office building has an annual NOI of $1,000,000 with the total annual mortgage payments of $800,000, thereby resulting in a Debt coverage ratio of $1,000,000 / $800,000 equaling 1.25:1.00. For uninsured commercial mortgages the normal range for Debt Coverage Ratio is 1.20 to 1.35, while insured mortgages can go as low as 1.10:1.00
The second prime commercial loan criterion is Loan-To-Value, which is explained below. The lender will take the lower value of these 2 criteria as the amount he/she is willing to fund.
Loan to Value Ratio for Commercial Mortgages
Normally, the other principal commercial mortgage funding limitation is the Loan-To-Value calculation. The lender takes the lesser of the agreed purchase price or the current appraised value and multiplies it by their determined mortgage funding per percentage. For example, if the building’s current appraised value is the lower of the 2 values at $1,000,000, and the lender has decided to apply a 70% LTV, this results in a mortgage funding amount of $700,000. The last step is for the lender to determine the lower of the Loan-To-Value amount and the maximum mortgage funding as calculated with the Debt Coverage Ratio. That lesser amount will then be the mortgage amount the lender is willing to advance. For uninsured commercial mortgages the Loan-to-Value normally ranges from 50% to 75%, while insured mortgages normally fund at 80% to 85%, but, in a very special case may get to 100%. Please note that many of these uninsured percentages have been significantly lowered by lenders due to Negative Leverage, as explained on the Home Page.
As alluded to above, virtually all commercial lenders require a formal appraisal of a multi-family, commercial or industrial building as part of their due diligence. Please note that, unless there has been a major change with the building, the age of an acceptable appraisal is usually 6 months, with sometimes a year old appraisal being acceptable. If your appraisal is unacceptable to the lender, either because it is dated and/or was not prepared by an appraiser acceptable to the lender, an updated or an entirely new appraisal may be required. To avoid duplication and extra costs, please get a list of approved appraisers from your lender immediately after your conditional offer to purchase has been accepted or you have decided to re-finance an existing commercial or industrial building.