Understanding Cap Rate in Relation to Commercial Lending

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A lot of times you will hear people talk about CAP rates in commercial lending.  When I first started doing commercial, I didn't understand it and asked a bunch of lender reps.  Very few lender reps even understood it.  They just had a basic idea.  But I assure you, underwriters know about CAP rates -- and if you want to close a lot of commercial loans, you better know about it as well.

The CAP rate; or capitalization rate, is the relationship of the net operating income (NOI) of the property divided by the sales price or appraised value.  So a property with $200K of NOI that sold for $2 Mill, sold at a 10 CAP -- (200,000 divided by 2 mill). Now, while CAP rates may vary some by city and property type, a general idea of CAP rates will help you screen out deals that don't make sense.  Knowing the CAP rates can help you estimate the real value of the property you are looking at financing and this can help you determine whether it is even a viable deal.  Generally, I can come within $100,000 on the appraised value on a property just by knowing the CAP rates and doing a simple calculation.

Most listing flyers and many borrowers think their property is worth a 7 CAP.  No lender in America will give someone a 7 CAP on a property in 2011. In 2007, average pricing was a 7 CAP and in some places like California, you were even seeing 5.5% CAP which is crazy.  A property barely cash flows at that CAP rate.  Today, 10 CAP is the safest number to use when underwriting and the lowest you will find most lenders willing to go is an 8.5 CAP.  Let me show you what I mean by an example....

Say a property has a $200K NOI.  On a 7 CAP that property is worth $2,857,000.  That was the price in 2007 nationally.  On a 10 CAP, that same property with the same NOI of $200K is worth $2 million even.  Today, prices are coming in closer to the 10 CAP number.  When I get a loan and screen it, I calculate my NOI and then divide by .1 (a 10 CAP) to see if we are even in the same ballpark.  Usually, the deal is either close or way off.  IF way off, you just saved yourself a ton of time working on a deal that will never appraise.  If close, you can have a better look.  There are lenders willing to underwrite at an 8.5 CAP so if I was close at 10, I know I can get it done by going to the lenders that underwrite more conservatively.  Our in-house lending goes at an 8.5 CAP rate and so do many local credit unions, and more localized lenders.  And different areas and property types support a lower CAP rate.  But the 10 CAP is a great place to quick screen and see if you are in the ballpark.  When a guy comes to me and wants cash out on his property that he bought in 2007 for $2.9 million, and he wants cash out at $2 million, he thinks he is at a 67% LTV because he thinks his property is worth $3 million though based on today's CAP rates, it is more likely worth closer to $2 million.  No one will cash him out above 80% which is where he really sits.  Knowing this will save you from doing a lot of work and then getting a low appraisal and having the deal tanked.  It saves you time and money.

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Education

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• commercial
• Lending
• Christopher
• Hills
• Cap
• Rate
• capitalization
• Investor
• Financing
• Cash
• Out