This article was posted on Wednesday, Oct 01, 2014

 The first part of this article will define the terms. The second part will review the use of capitalization rates, a critical element of mortgage carry calculations. The third section will address the mortgage constant and discuss how it impacts cash flows. The fourth portion will illustrate positive mortgage carry. This can be a double-edged sword, however, and the final section will illustrate negative mortgage carry. 

 

Part 1: GLOSSARY

 

Cap Rate: A measurement of expected yield during the first year of ownership.  If a yield over the entire period of ownership is desired, the Internal Rate of  Return (IRR) or Financial Management Rate of Return (FMRR) – not covered here – is probably more useful. 

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Cap Rate Formulae – Capitalization Rate: Net Operating Income divided by Price equals Cap Rate (in decimals). Ex:  $10,000 NOI divided by $100,000 Price equals 0.10 Capitalization Rate (10%).

 

Price:  Net Operating Income divided by Cap Rate equals Price. Ex: $10,000 NOI  divided by 0.10 Cap Rate equals $100,000.

 

Net Operating IncomePrice times Cap Rate equals NOI. Ex: $100,000 Price times 0.10 Cap Rate equals $10,000. 

 

Carry:  The Carry Trade borrows at one rate to reinvest at another (higher) rate. This is not uncommon amongst foreign exchange traders, but is also occasionally available in mortgages. It is another utensil in the toolbox. 

 

Mortgage Constant:  Annual debt service (includes principle and interest) divided by amount borrowed.  

 

NOI: Net Operating Income. This is the money remaining at the end of the year after paying all the expenses of ownership except the mortgage. Debt service (principle and interest) comes out of the NOI, leaving Before Tax Cash Flow. 

 

Part 2: REVIEW OF CAPITALIZATION RATES

 

What to look for:  Stream of income investments (as opposed to speculative investments, as in “Yeah, but maybe we can sell it for more in a couple years”) can be compared by weighing their first year’s risk adjusted net returns. From a purely income perspective, an absentee owned car wash at a (hypothetical) 17% cap rate is better than an apartment building at 7% cap.  Risk adjusted, big caps are better than small ones.

 

How does it vary? At any given NOI, as cap rates go down values go up. A $10,000 NOI capitalized at 8% yields a value of $125,000. At a 5% cap rate, that same NOI would be worth $200,000. Alternatively, at any given NOI as cap rates go up (say from 5% to 8%) values go down. Think of a teeter-totter with cap rates on one end and value on the other. When cap rates go up, values go down.

 

Complication 1:  The underlying premise is that NOI acts as the fulcrum upon which the teeter-totter pivots. Over time, thankfully, the net operating income of apartment buildings tends to rise. If cap rates remain the same while the NOI rises, values go up. You’re capitalizing a greater stream of income at the same cap rate. Ex: A building’s NOI is $83,000 and is purchased at a 7% cap rate. Purchase price was $1,186,000 (rounded). Time passes and net operating income rises to $100,000. Cap rates remain unchanged. The value of the building at the higher NOI is ($100,000 divided by 0.07 = $1,429,000 (rounded). Takeaway: If cap rates remain the same, the building’s value rises or falls depending on the changes in net income.

 

Complication 2: Cap rates are joined at the hip to ever-changing interest rates. As interest rates change, cap rates can be expected to follow. Low interest rates usually mean low cap rates. If net income remains the same, but cap rates rise, the value of the property will decline. In periods when the cap rate drops but net income remains the same, the property value will increase. You’re capitalizing a fixed stream of income at a greater (or lesser) cap rate. Ex: $100,000 NOI capitalized at 9% (0.09) gives a value of $1,111,000 (rounded). At 7% (0.07) the value was $1,429,000. Takeaway: If the NOI remains the same, value rises or falls based on changes in cap rates. 

 

PART 3: MORTGAGE CONSTANT: ANOTHER TOOL

 

Theory: The Net Operating Income provides the return of and on the mortgage principal and on the down payment. This may want a little explanation. If “A” is the down payment and “B” is the loan, then “A” plus “B” becomes the purchase price.

 

 The “B” people (“B” for bank) want to get a return on their money while the loan is outstanding (return on) and they hope to get their principle back over time (return of).

 

The “A” person, the buyer who makes the down payment, wants to get a return on his money during his period of ownership. But there is no return of his down payment through cash flow. The owner is supposed to maintain an equity investment for as long as he owns the property.

 

So, the NOI needs to cover return of the loan principle and return on both the remaining loan balance and the (hopefully) ever-increasing equity portion. We shall soon see that the return on doesn’t have to be the same for the bank as for the borrower. 

 

Example 1: (30 year mortgage)

 

Purchase price:            $1,000,000
Down Payment:          $300,000
Mortgage Amount:     $700,000
Cap Rate 7%:              $70,000 (NOI)
[$1,000,000 times 0.07]
                   

 

Mortgage Pmt:            $42,000 (annual P&I)
Mtg Constant:             6%
                                    [$42,000 divided by $700,000]
Cash Flow:                  $28,000 (annual)
                                    [$70,000 minus $42,000]
Yield on Dwn Pmt:     9% (rounded)
                                    [$28,000 divided by $300,000]       

 

Just to emphasize, due to Mortgage Carry, this is a 9% (rounded) cash yield on the down payment. Today’s interest rate for the 10 year Treasury Note is 2.40%.  That’s a big difference, huh? 

 

PART 4: POSITIVE MORTGAGE CARRY

 

Question:  How can a building sell at a 7% cap rate yet generate 9% cash-on-cash yield to the borrower? Only through favorable borrowing.

 

Explanation:  Since the 7% cap rate (what the buyer gets) is more than the 6% mortgage constant (what the buyer pays: principal and interest repayment for the borrower’s loan), the buyer is earning 1% on amount borrowed. Life is good. Pass the cookies. 

 

Example:       

 

NOI                     $70,000      

 

Less Mtg Pmt      $42,000 (annual P&I)

 

Cash Flow           $28,000 (annual) 

 

That $28,000 cash flow consists of the 7% cap rate on the $300,000 down payment ($21,000) plus a 1% overage on the $700,000 purchase loan ($7,000).  

 

PART 5: NEGATIVE MORTGAGE CARRY 

 

Example 2: (15 year mortgage)

 

Purchase Price :           $1,000,000

 

Down Payment:          $300,000

 

Mortgage Amount:     $700,000

 

Cap Rate 7%:              $70,000 (NOI)

 

                                    [$1,000,000 times 0.07]

 

Mortgage Pmt:            $64,000 (annual P&I)

 

Mtg Constant:             9%

 

                                    [$64,000 divided by $700,000]

 

Cash Flow:                  $6,000 (annual)

 

                                    [$70,000 minus $64,000]

 

Yield on Dwn Pmt:     2% (rounded)

 

                                    [$28,000 divided by $300,000]     

 

Takeaway: Mortgage Carry can be positive (borrower’s yield on the down payment exceeds the cap rate) or negative (borrower’s yield on her down payment is less than the cap rate).  

 

This article is for informational purposes only and is not intended as professional advice. For specific circumstances, please contact an appropriately licensed professional.  Klarise Yahya is a Commercial Mortgage Broker. If you are thinking of refinancing or purchasing five units or more, Klarise Yahya can probably help. Find out how much you can borrow. For a complimentary mortgage analysis, please call her at (818) 414-7830 or email [email protected]. 

 

If you’ve missed some of the prior articles, basic beginner guidelines on successful investing are in my book “Stairway to Wealth” available at www.LuLu.com

 

 

 

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