Capital Rates (Cap Rates) are commonly used to determine the value of cash flowing commercial real estate properties. The cap rate is the rate of return on a commercial real estate property based on the income that the property is expected to generate. A simple formula to derive a value is: Net Operating Income (NOI) / Cap Rate = Value.
In theory, this formula and approach to determining value is simple. However, as we are in a historically low cap rate environment, this commonly-used approach can expose many potential issues. For example, let’s consider the example of a property that generates an approximate $300,000 NOI (net operating income). At a 6.00% cap rate, the value of the property would be $5,000,000. Now, assume the property secures an interest-only loan with an 80% loan to value the loan would be $4,000,000. Due to the high loan to value, a traditional lender would likely require either a full or a partial personal guaranty.
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In situations involving personal guarantees, borrowers are exposed to changes in cap rates. For example, a slight increase in the cap rate to 6.25% would decrease the value of the property by $200,000, to $4,800,000, implying the $4,000,000 loan is now at an 83.3% loan to value. A borrower could be operating the property well but if the cap rate increases to 6.50% the value of the property would fall by $385,000 to roughly $4,615,000, which means the loan is now at an 86.7% loan to value and the borrower’s personal guarantee means an increase in personal liability. These scenarios, which are based on small changes to cap rates, illustrate the dramatic impact on the property values changes in cap rates can have – and how personal guarantees can keep a lot of borrowers/property investors up at night.
Traditional Lenders are risk-averse and typically look for one or a few of the following:
- Depending on the property type and loan to value, a traditional lender may be looking for some form of guaranty, especially for higher leveraged loans.
- Some traditional lenders may also look for a higher minimum debt yield, which would mean a lower loan amount. The debt yield tests the property’s ability to support the total loan amount; essentially, this determines the interest rate that the property’s NOI can support.
- A traditional lender will typically have loan covenants that if not adhered to may require loan rebalancing/pay-down, which may or may not be based on a new appraisal.
A new breed of non-recourse private lenders, like iBorrow, enable borrowers to avoid these problems and provide a financing that is fast, flexible and reliable and that can also be tailored to the specific needs of each borrower. Private lenders, like iBorrow, do their due diligence thoroughly but also quickly.
The following are some other advantages iBorrow has over traditional lenders:
- iBorrow provides non-recourse loans, which means the debt is secured by collateral, such as property. Simple application process and a Letter of Intent typically within 48 hours. They underwrite the property instead of the borrower.
- iBorrow underwrites all of its loans in-house, which enables them to close deals reliably in as little as 2 weeks, versus banks and other traditional lenders which typically average 90 days or more to close a deal.
- Creative and flexible loan structures that are custom tailored to your specific needs.
Cap rates are a standard measure of value for commercial properties; they also help to illustrate how dramatically a borrower’s personal liability can be impacted by small changes in their value and why non-recourse private lending is an important option for borrowers to consider.