Property Value – As with a residential home loan, there is careful consideration of the condition and value of the property’s facilities and land occupied. This isn’t the major criteria in granting a mortgage, or in deciding how much to loan, but it is one of the factors.

Cash Flow & Cap Rate in Mortgage Decision – Apartment & multifamily mortgages are decided primarily on the cash flow, which is used to calculate a capitalization or cap rate, and this cap rate is compared to other properties for sale and recently sold in the area. If recent apartment sales have closed at an average cap rate of 9%, and the subject property is at 11%, the lender will be more likely to originate a mortgage on the property.

The cash flow, or net operating income component, is a major focus of the lender. Careful scrutiny of financial data will be done to verify rental income is accurate. Just as carefully analyzed will be operating expenses. Are they normal, better or worse than the typical apartment or multifamily project? Are they likely to change for better or worse under new ownership? Are local business and economy healthy, with any improvement or problems foreseen? Any softening of rental demand could cause a drop in average rents, cutting cash flow, and placing the mortgage into default. Higher vacancy rates due to a major employer leaving the area could do the same.

DSCR, Debt Service Recovery Ratio – This ratio is used by the lender to determine how much to loan. Many use 1.25 or thereabout for this number, and it indicates a multiplier of cash flow over the mortgage payment. $10,000 in monthly cash flow, with a monthly mortgage payment of $8000 would yield this 1.25 DSCR. Higher is better, lower might kill a deal.

But, the good news is that a profitable property, with a DSCR higher than 1.25, a strong and secure cash flow, and a cap rate higher than other comparable properties is a strong candidate for a great mortgage deal. It’s not credit score or job income, but property financial performance that seals the deal.

I’ll share more with you soon…

Warm Regards,

Karen Hanover, CCIM Candidate
Apartment Education Institute, President

The Cap Rate Calculation

Simply stated, the cap rate of an apartment property is the net operating income divided by the price, either asking or sold price.  It represents the rate at which the investment is recaptured by income.  The higher the cap rate applied to the same income, the lower the price.  The lower the cap rate applied to income, the higher the selling price.  In other words, a high price paid for income has a slower recapture, or lower percentage rate to get the investor’s investment back.  An example:

Net Operating Income / Price  =  Cap Rate

$105,000 / $1,500,000  =  .07, or a Cap Rate of 7%

In this calculation, the price could be either an asking price, or a recently sold price, depending on the buyer or seller’s goals.  If a buyer is considering buying the property in this calculation, the “price” in the calc is the asking price.  The buyer would get the cap rates of comparable properties sold recently in the area to see if this cap rate compares favorably.  If other properties have been selling at 9% cap rates, the price would need to come down to get that cap rate:

$105,000 / .09  =  $1,167,000

As other properties are selling at a 9% cap rate, to be competitive this property would need to be priced at $1,167,000 rather than the higher price it’s listed at with the 7% cap rate.

Looking from a seller’s side, there is a property owned that has a net operating income of $125,000, and the seller would like to determine a probable asking price for the listing.  Going out and getting the comps, prevailing cap rates average 8% for previous sales.  What would a probable listing price be, all other factors being similar to previous comparable sales?

$125,000 / .08  =  $1,562,500

If this seller wants to move the property quickly, using a 9% cap rate would yield a selling price of approximately $1,389,000.  Buyers and lenders will see more value in this apartment property if others are listed at the lower cap rate.

Karen Hanover, CCIM Candidate
Apartment Education Institute, President