Commercial Investment Real Estate is the magazine of the CCIM Institute, the leading provider of commercial real estate education. CIRE covers market trends, current developments, and business strategies within the commercial real estate field.
Issue link: http://cire.epubxp.com/i/164181
Lenders and investors see ROI differently. by Eric B. Garfield, CCIM, MAI Since the market crash fve years ago, CCIMs and other comre e mercial real estate professionals have been asked far too ofen, i "What is it worth?" With a paucity of sales from which to extract investmen n investment benchmarks, many of us were limited to guesswork, mathemat t mathematics, or both. To add to our challenges, credit remained tight, forcing a retreat of some lenders from commercial real estate forci i all togethe together. e When fnancing was not at issue, some of us turned to mathemata ics to expla the market in a period without empirical transactions. explain p (See "Cap Rate Calculations," Sept./Oct. 2009 CIRE) But as we head deeper into recovery and lenders return to the market, let's take a closer look at how lenders might "back of the envelope" or underwrite real estate today by using the Gettel formula to determine capitalization rates. Te information may help us close more escrows in our eforts to understand the plight of lenders. Kudryashka/Veer The Lender's Perspective In the 2009 article, we discussed L.W. Ellwood's original cap rate analysis, with its algebraic origins stemming from risk/reward models infuenced by mortgage and equity rates of return. Te Ellwood formula with its comprehensive algorithms gave way to a streamlined algebraic equation proposed by Charles Akerson, MAI. With the return of lenders to commercial investment markets, today's all-cash deals are giving way to leveraged transactions. Let's look at another formula that is streamlined for quick cap rate calculation based on the most common components in the Ellwood and Akerson formulas: leverage, or loan-to-value ratios; cost of debt, or interest rates; and debt coverage ratios, which is the cash fow available for debt servicing. Tis is the Gettel formula. CCIM.com Te Gettel formula explains cap rates in a simplifed fashion by examining a commercial real estate investment from the perspective of a bank lending committee. In "Good Grief, Another Method of Selecting Capitalization Rates" (Appraisal Journal, 1978, p.98), Ronald Gettel makes the point that "if the appraiser has credible data on debt coverage factors but lacks data for a convincing projection of, say, future depreciation or appreciation, he may feel justifed in opting for this simpler method [debt coverage]." Te Gettel formula, which is also known as the debt coverage formula (Te Appraisal of Real Estate, 13th edition, p. 508) explains the cap rate as follows: R = M x Rm x DCSR, whereas: R = capitalization rate; M = loan-to-value ratio (percentage of market value that is fnanced); Rm = mortgage constant; the "mortgage cap rate" or return on/of a mortgage from annual loan payment divided by the year 1 loan balance; and DCSR = debt coverage service ratio Inherent in the Gettel formula are the same risk/reward factors that the Ellwood and Akerson formulas embraced. While Ellwood and Akerson use K-factors or sinking funds to explain the amortization of debt, the build-up of equity, and the constant rate of change in value and income, in Gettel, an assumption of principal pay-down remains a result of amortization of debt. In summary, the Gettel formula yields similar results to Akerson but requires substantially less calculation, as the investor's rate of return (equity) is less consequential from the lending committee perspective. September | October | 2013 39