Nearly all commercial real estate investment transactions are financed with some combination of debt and equity. “Debt” is the term used to refer to the loan provided by a real estate lender and the amount of it can have a significant impact on the profitability of an investment. But, the loan terms and conditions offered by lenders can vary widely, which can make it tricky to calculate profitability given the number of scenarios. Fortunately, there is a quick and easy way to do this using a metric called the “mortgage constant.”
In this article, the mortgage constant is defined and its application in a commercial real estate investment is illustrated. When finished, readers will have a deeper understanding of this term and a practical example of how it is used to evaluate a commercial real estate investment opportunity.
At First National Realty Partners, we always use the mortgage constant as part of the evaluation of our own deals. To learn more about our current offerings, click here.
What is the Mortgage Constant?
The mortgage constant – sometimes called the loan constant – is a performance metric that measures the amount of annual debt service per dollar of loan provided by the lender. Put another way, it is the percentage of money paid each year to service a loan, given the amount of the same loan.
Why is the Mortgage Constant Important?
For an investor, the mortgage constant is important because it helps to determine the amount of money needed each year to service a commercial mortgage. When this number is compared to the amount of cash flow a property produces, a measure of profitability is the result.
How to Calculate The Mortgage Constant
The formula used to calculate the mortgage constant is the total annual loan payments divided by the amount of the mortgage loan.
Mortgage Constant = Annual Debt Service Loan Amount
To understand how this formula works, it is helpful to break down the components.
In the numerator of the equation, annual debt service can be obtained in one of two ways. First, it can be calculated based on the mortgage amount, interest rate, and amortization period. Or, it can be provided by the lender as part of the loan underwriting process.
The loan amount is just that, the amount of the loan that will be provided by the lender. During the initial phases of analysis, the exact amount may not be known so an estimate may be required.
Mortgage Constant Example
To illustrate how the mortgage constant works, an example is helpful.
Suppose that a borrower is considering the purchase of a small retail shopping center. As part of this transaction, they will obtain a $2,000,000 loan with a 6% interest rate and a 20 year amortization. In a spreadsheet or financial calculator, these inputs can be used to calculate the loan’s monthly payments of $14,328. These monthly payments can be multiplied by 12 to get annual payments of $171,943.
When the total annual loan payments are divided by the amount of the mortgage loan, the mortgage constant is calculated to be 8.60% ($171,943/$2,000,000). But, what does this mean?
In short, it means that the borrower must pay 8.60% of the loan amount per year in debt service.
Benefits and Risks of Using the Mortgage Constant
The major benefit of using the mortgage constant as part of evaluating a potential investment is that it is quick, easy to calculate, and the information needed is readily available. In addition, the result can provide valuable information about the potential profitability of a deal.
The primary drawback of the mortgage constant is that it is fixed in time. In other words, the denominator of the equation – the loan amount – changes each time a principal and interest payment is made. As a result, it should not be solely relied upon when making an investment decision. It should be used as a single data point, amongst many others.
Mortgage Constant vs. Capitalization Rate
A comparison between the mortgage constant and the cap rate is what provides valuable insight into the leverage and/or profitability of the commercial property transaction.
As a reminder, the cap rate is the ratio of a property’s net operating income (NOI) to its purchase price. It can be used as an indication of the property’s annual rate of return, assuming it was purchased with cash. The mortgage constant can be compared to the cap rate to determine if the property is profitable.
In the example above, the mortgage constant was calculated to be 8.60%. Now assume that this same property had a calculated cap rate of 9.50%. Because the mortgage constant is less than the cap rate, it is a quick way to determine that this would be a profitable investment. If the cap rate was less than the mortgage constant, it would be an indication that there is either too much leverage (debt) or that the valuation (price) is too high.
Summary & Conclusion
The mortgage constant is a property performance metric used by real estate investors to determine the amount of debt service that must be paid each year relative to the loan balance. The lower the mortgage constant, the better.
The primary benefit of this calculation is that it is quick, easy, and can be made with information that is easily obtained. The risk is that it is just a point in time because the total loan amount changes every month when a mortgage payment is made. As a result, it should not be used in isolation to make an investment decision.
The true utility of the mortgage constant can be seen when it is compared to a property’s cap rate. As long as the mortgage constant is less than the cap rate, the property is considered to be positively leveraged and/or profitable.
Interested In Learning More?
First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. With an intentional focus on finding world-class, multi-tenanted assets well below intrinsic value, we seek to create superior long-term, risk-adjusted returns for our investors while creating strong economic assets for the communities we invest in.
If you are an Accredited Real Estate Investor and would like to learn more about our investment opportunities, contact us at (800) 605-4966 or [email protected] for more information.
