Cap Rates 101: How Do Cap Rates Impact The Loan On A Commercial Property?

If you want to keep your pipeline filled, you need to be well-informed about challenges and opportunities your prospects and clients are encountering in the marketplace. Successful business bankers are able to confidently offer up insight on a wide range of topics. Why is this important?  Referral sources and prospects will see you as a source of valuable information and not just as a product pusher!  You will be able to build rapport with them and quickly convince them that you can help them either solve the problems they are experiencing or help them take advantage of some opportunity they believe will help them grow their business.

Successful business owners tend to invest in commercial real estate. Their commercial real estate broker has probably explained the concept of cap rates. However, the broker likely did not explain how cap rates impact how much debt a commercial property will support. This is the opportunity to become your client’s or prospect’s hero! This is the kind of stuff that helps you jump to the front of the line…that will help you bury the 500 other bankers that have been calling on your client or your prospect!

The capitalization rate (aka cap rate) is a crucial metric that impacts investor CRE purchase and refinance transactions. The cap rate can impact the down payment and the loan amount an investor CRE property. Let’s say that your client wants to purchase an investor commercial property and the commercial broker states that the Net Operating Income (NOI) for the property is $135,801 with a cap rate of 8%. You can quickly estimate the value of the property using a simple formula (Estimated Value = NOI divided by Cap Rate). So..$135,801 divided by 8% equals $1,697,512. On investor commercial real estate deals, the NOI of the property determines how debt the property will support.  If you don’t know how to underwrite investor commercial real estate deals, enroll in the Business Banker Development Program at www.bizpetrol.com. Just for fun, let’s say you underwrite the property and determine it supports a loan of $1,025,000 based on NOI of $135,801.  This translates to a loan-to-value (LTV) of 60% which means your client has to come up with a 40% down payment which is fairly typical for investor commercial real estate in a major metropolitan market.  If your credit policy states that the max LTV for investor CRE loans is 60%, you are good to go!

Let’s change the cap rate to see what happens. Let’s say that the cap rate is 3% instead of 8% as shown above. Let’s estimate the value of the property using a 3% cap rate ($135,801 divided by 3% equals an estimated value of $4,526,700). See the power of the cap rate? A cap rate of 8% produced an estimated value of $1,697,512 and a cap rate of 3% produced an estimate market value of $4,526,700. Huge difference! However, the loan amount the property can support based on a 3% cap rate does not change because the NOI did not change.  The NOI is still $135,801, and the property still only supports a loan of $1,025,000. A property with a 3% cap rate is likely located in a more desirable market and investors see a lot of potential in the market. The LTV at a cap rate of 3% if 22.6% which means your client has to come up with a 77.4% down payment!  Crazy, right? A traditional lender…like a bank…will underwrite to the NOI. An asset-based lender may lend more based on the value of the property.

Let’s change the cap rate again to see what happens. Let’s say that the cap rate is 10% instead of original 8% as shown above.  Let’s estimate the value of the property using a 10% cap rate ($135,801 divided by 10% equals an estimated value of $1,358,010). A cap rate of 8% produced an estimated value of $1,697,512 and a cap rate of 10% produced an estimate market value of $1,358,010. But something different is about to happen! The NOI did not change, and it is still $135,801! A property with an 8% or 10% cap rate is likely located in a less desirable market and investors don’t see a lot of potential in the market. At an 8% cap rate, we calculated the LTV at 60% and determined we were good to go because the bank’s max LTV for investor CRE is 60%.  However, the LTV at a 10% cap rate is 75%!  Unless you can get a LTV policy exception, you will have to either lower the loan amount or pass on the deal!

When does the cap rate change? The cap rate is driven by the market that the property is located in and economic market forces like rising interest rates, unemployment rate, etc. A more desirable market will have lower cap rates. This means that investors are willing to pay more for the property because they see market-driven long-term value. You will see higher cap rates in markets that are not as “hot” or desirable.  The upside of a higher cap rate (as explained in the article) is that you get a higher return on your investment.   

How does the cap rate impact owner-occupied commercial real estate? You can still use the cap rate to estimate the value of the owner-occupied commercial real estate. The big difference is that the loan amount on an owner-occupied property is based on the amount of debt the operating business supports. Additionally, you can get up to 90% financing on owner-occupied commercial real estate using SBA loans!  The Business Banker Development Program can also teach you how to underwrite owner-occupied commercial real estate loans. You can access the program at www.bizpetrol.com. 

These scenarios do play out in the marketplace. You are going to be a business banking superstar if you can explain this concept to your clients, prospects or referral sources!

Bizpetrol has information, insight and tools that will help you become a Business Banking Superstar! Enroll in the Business Banker Development Program. Learn more at https://www.bizpetrol.com/business-bankers. You can see all the Business Banking articles (like this one) at www.bizpetrol.com/blog. You can access a series of how-to business banker guides at https://www.bizpetrol.com/Downloads-Free.