Cap Rate Calculations Today: Lenders and investors see ROI differently.
Since the market crash five years ago, CCIMs and other commercial real estate professionals have been asked far too often, “What is it worth?” With a paucity of sales from which to extract investment benchmarks, many of us were limited to guesswork, mathematics, or both. To add to our challenges, credit remained tight, forcing a retreat of some lenders from commercial real estate all together.
When financing was not at issue, some of us turned to mathematics to explain the market in a period without empirical transactions. (See “Cap Rate Calculations,” Sept./Oct. 2009 CIRE) But as we head deeper into recovery and lenders return to the market, let’s take a closer look at how lenders might “back of the envelope” or underwrite real estate today by using the Gettel formula to determine capitalization rates. The information may help us close more escrows in our efforts to understand the plight of lenders.
The Lender’s Perspective
In the 2009 article, we discussed L.W. Ellwood’s original cap rate analysis, with its algebraic origins stemming from risk/reward models influenced by mortgage and equity rates of return. The Ellwood formula with its comprehensive algorithms gave way to a streamlined algebraic equation proposed by Charles Akerson, MAI.
With the return of lenders to commercial investment markets, today’s all-cash deals are giving way to leveraged transactions. Let’s look at another formula that is streamlined for quick cap rate calculation based on the most common components in the Ellwood and Akerson formulas: leverage, or loan-to-value ratios; cost of debt, or interest rates; and debt coverage ratios, which is the cash flow available for debt servicing. This is the Gettel formula.
Commercial Investment Real Estate Magazine
September/October 2013 Issue
Read the entire article here.