How To Calculate The Loan Constant (Cost Of Capital)
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How To Calculate The Loan Constant (Cost Of Capital)The cost of capital for a property is called the Loan Constant (Constant) or Mortgage Constant. Allloans have a certain interest rate and, unless there is an interest-only portion to the loan, all loans willrequire a principal and interest payment. The principal is calculated based upon the amortization ofthe loan. Thus, if the loan has a 30-year amortization, which is equal to 360 months, the principalmust be paid in 360 installments so the loan is paid in full on the last loan payment.The quoted interest rate of a loan is strictly the amount of interest that loan accrues. The loanconstant, on the other hand, is expressed as an interest rate that incorporates both the interest andprincipal repayment of a loan. The formula is:Loan Constant = [Interest Rate / 12] / (1 - (1 / (1 + [interest rate / 12]) ^ n))n = the number of months in the loan termExample 1: Suppose an investor received a loan for $4,000,000 at a 5.50% interest rate with a 30-year amortization. We can calculate the required annual loan payments once the loan constant isknown.Constant = [.055 / 12] / (1 - (1 / (1 + (.055 / 12]) ^ 360))Constant =.06813 x 100 = 6.813% (rounded)Annual payments = $4,000,000 *.06813 = $272,520While the property has an interest rate of 5.50% the investors actual cost of capital for the loan is6.813% once the principal payment has been factored. If the above loan scenario has a 1.25x debtservice coverage ratio (DSCR) requirement then an investor knows that the property must have atleast the following NOI to support the loan:$272,520 x 1.25 = $340,650Consider that the reverse also holds true. A borrower can factor his potential debt service loan withthe loan constant as long as he knows the NOI.Example 2: A borrower wants to refinance his loan. His NOI is $560,000 and he has heard that hislocal bank will give him an interest rate of 6.25% for 25 years with a minimum DSCR of 1.25. What isthe maximum loan he can borrower subject to an appraisal?Constant = [.0625 / 12] / (1 - (1 / (1 + (.0625 / 12]) ^ 300))Constant =.07916 x 100 = 7.916% (rounded)Since the borrower knows the Debt Service Coverage Ratio must be 125% more than annual debtpayments he can calculate the annual payments as the following:$560,000 = $448,0001.25With $448,000 of the propertys net operating income available to service the debt payments, hismaximum possible mortgage based on debt service would be:$448,000 = $5,659,424.07916As illustrated, the loan constant is a tool that can help a borrower easily understand the potential debt
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service associated with a property based upon a certain net operating income. Any borrower shouldmake sure they check the loan constant with their lender to ensure that it matches his assumptions.For example, FHA multifamily mortgages have a mortgage insurance premium that is also factoredinto the loan constant which raises a propertys cost of capital. A few other items to remember are:Shortcoming #1: The constant only works for fixed rate loans. For adjustable rate mortgages thathave changing monthly interest rates lenders will typically underwrite the maximum possible interestrate for that loan. Find out from your lender what is appropriate when modeling debt assumptions.Shortcoming #2: The constant changes based upon the amortization of the mortgage. While notnecessarily a shortcoming, it is important to understand the terms of any loan quote you receive froma lender or if your loan assumptions are accurate for a particular property or market. The shorter theamortization period of a loan, the higher the propertys cost of capital.Shortcoming #3: The constant does not factor interest-only periods. In the current lendingenvironments, most lenders use an amortizing constant. When modeling cash flow it is important tonote an interest only periods but although it will increase the cash-on-cash returns, it will not changethe loan amount.Sherman oaks real estate
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