The Importance of Mortgage Constant in Commercial Real Estate
Mortgage constant, or loan constant, is a metric that represents the amount of a loan, in percentage, which will be paid back each year. Mortgage constant compares the annual debt service of a prospective commercial real estate loan to the entire loan amount.
The loan constant is sometimes referred to as mortgage cap rate or mortgage capitalization rate. This is because the loan constant of a commercial mortgage is, in essence, the cap rate of the loan.
How to Calculate Mortgage Constant
To find the loan constant of a mortgage, you can take the annual debt service and divide it by the amount of the loan.
Therefore, the formula for loan constant is:
Loan Constant = Annual Debt Service/Loan Amount
For example, an 80% LTV, 30-year, fully amortizing loan of $5,000,000 with a 4% interest rate would have an annual debt service of $286,449.
$286,449/$5,000,000 = 5.7%
A 5.7% loan constant is neither good nor bad, as it needs to be compared to other metrics, like debt yield, to help determine the profitability of a property.
Mortgage Constant vs. Debt Yield
Debt yield is the opposite of the mortgage constant. Debt yield is taken by dividing the NOI (net operating income) of property by the total loan amount. NOI is calculated by taking a property’s gross rental income and any ancillary income and subtracting taxes and operational costs, such as maintenance and property management fees. It does not factor in debt service.
The formula for debt yield is:
Debt Yield = Net Operating Income/Loan Amount
If a property’s debt yield is higher than its mortgage constant, the property is generating positive cash flow.
For example, if a property had a $5,000,000 loan on it, and was generating $400,000 in NOI, it would have a debt yield of 8%.
If we use the same loan constant in the example above, 5.7%, the property would be generating income, since the 8% debt yield is higher than the 5.7% loan constant.
Loan Constant vs. Cap Rate
If a property’s loan constant is smaller than its cap rate, the property is profitable, while if the loan constant is higher than the cap rate, the property is losing money.
For example, if, in the example property above, the $5,000,000 loan was set at 80% LTV, the market value of the property would be $6.25 million. Cap rate is determined by taking the property’s NOI, in this case, $400,000, and dividing it by the market value of $6.25 million.
$400,000/$6.25 million = 6.4% Cap Rate
Since the cap rate, 6.4%, is higher than the debt yield, 5.7%, the property is profitable.
Mortgage Constant’s Application to Interest-Only and Variable-Rate Loans
Due to the fact that the loan principal and interest rates are the major factors in calculating the mortgage constant of a loan, mortgage constant is not an applicable metric for interest-only or variable-rate (floating-rate) loans. In these cases, lenders will have to rely on other metrics, like LTV, DSCR, and debt yield.
Using Mortgage Constant and the Band of Investment Model to Estimate Cap Rate
If an appraiser does not know the cap rate of a specific property but wants to estimate it, they can use a financial rule of thumb referred to as the “band of investment” model, which averages the returns of debt and equity to create an estimated cap rate.
First, the appraiser could survey lenders about the terms they are willing to offer for similar properties in the same local area to determine the loan constant. For instance, they may find that lenders are offering the same 80% LTV, 30-year, fully amortizing loan at a 4% interest rate, leading to the same mortgage constant of 5.7%.
Next, the appraiser cold survey investors in the area to determine what their required cash-on-cash return is. Let’s say this is 12%. The appraiser can calculate the weighted average of these two numbers to generate an estimated cap rate of the property. (5.7% x .80) + (12% x .20) = 6.96%.
Mortgage Constant and Other Commercial Lending Underwriting Factors
As previously mentioned, loan constant is used along with LTV, DSCR, and debt yield in order to underwrite commercial or multifamily loans. Other factors used in the underwriting process include the background, credit score, and real estate experience of the Key Principals (KPs) taking out the loan, as well as the condition, age, occupancy rate, and market factors, including the location of the subject property.
Lenders will generally require a list of documentation, including the property’s rent roll, historical profit, and loss (P&L) statements, as well as third-party reports such as a full appraisal by a licensed appraiser, a Phase I Environmental Assessment (ESA), and in some cases, additional reports, like zoning reports and market studies.
In Conclusion
Mortgage constant, or loan constant is a metric that is mainly used to calculate the amount of debt service that needs to be paid off annually relative to the loan balance. Lower mortgage constants, which are associated with longer amortizations and lower interest rates, are better than larger mortgage constants, as a low mortgage constant generally means a higher cash-on-cash return and higher IRR for the subject property.