As we enter 2024, investors wait with bated breath for a change in financing and the expected Federal Reserve drop in interest rates in the coming year.
To quickly understand your given terms in relation to your expected investment cap rate, consider the loan constant as an easy measuring tool.
Understanding the Loan Constant
The loan constant, also known as the debt service constant or mortgage constant, is a critical financial metric that represents the ratio of annual debt service to the total loan amount. In simpler terms, it is the percentage of the original loan that a borrower must repay annually to cover both principal and interest. The formula for calculating the loan constant is as follows:
Loan Constant = Annual Debt Service ÷ Loan Amount
Annual Debt Service includes both principal and interest payments over the course of a year. Loan Amount is the total amount borrowed.
This number, expressed as a percentage, takes into account the repayment of principal and interest, whereas the interest rate simply takes into account interest payments.
It is important to note that loan constants work when the interest rate is fixed. A variable rate will not provide a consistent metric.
Importance of Loan Constant for Multifamily Investors
The concept of loan constant is especially relevant in investment real estate, since compared to the capitalization rate, an investor can tell if they will actually make or lose money on the part of the investment they finance. For example, if an investor is buying an apartment building with a 7% cap rate and their loan constant is 6%, then they will be earning 1% on the borrowed money and 7% on equity. However, if the loan constant is 7.5%, then the investor would be losing half of 1% on the mortgaged part of the investment.
As an investor, you would want the loan constant to be lower than the cap rate.
Similarly, the cash on cash metric will show the reverse of loan constant — for the cash invested into the deal, what return are you gaining? Cash on Cash = Cash Flow After Debt Payments ÷ Equity Invested (Down Payment + Closing Costs).
Use of the Loan Constant
- Risk Assessment: Investors use the loan constant as a risk assessment tool. A higher loan constant indicates a greater financial burden on the property, potentially leading to higher default risks. Conversely, a lower loan constant may suggest a more favorable debt structure, reducing the risk of financial strain on the investment.
- Comparative Analysis: When evaluating multiple multifamily properties, investors can use the loan constant to compare financing terms. It provides a standardized metric that allows for a more accurate comparison of the financial obligations associated with different loans, enabling investors to make more informed decisions.
Conclusion
In the dynamic landscape of multifamily property investment, mastering the concept of the loan constant is a valuable skill for investors. This metric serves as a compass, guiding investors through the complexities of financing terms and providing a reliable indicator of a property’s financial health.
If you are looking to find better leverage for your investments and would like a complimentary review of your property’s value, contact us today to schedule.
