Real Estate Cost of Capital

Sep 3, 2011 by Rental Property    2 Comments    Posted under: Financing rental property

• Tweet
• Sharebar

• Tweet

The Real Estate Cost of Capital is the first of the three secondary financing elements that affect real estate financing and, consequently, real estate value. The cost to borrow funds is expressed in terms of an interest rate and represents the portion of the loan payment that the lender charges for loaning money. Changes in the interest rate charged to purchase income-producing property have a direct effect on the property’s value. I will explore in great detail the three primary appraisal methods, one of which is the income capitalization method. This appraisal method rests on the premise that a stream of income can be converted into a single capital value. If there is a reduction in the stream of income, the capital value must likewise be reduced. An increase to any degree in the cost of funds borrowed would have a negative effect on an investment property’s income stream and would subsequently reduce its capital value.

The cost of capital, or interest rate, or cost of funds, varies widely among lenders. Both banks and mortgage companies tend to be fairly competitive, as do conduit lenders. Banks typically offer loans for shorter durations and price their loans using the prime lending rate as the bench- mark. Mortgage companies, on the other hand, often offer loans for longer durations and price them using an index such as Treasury bills or the London Interbank Offered Rate (LIBOR). Likewise, conduit loans are also benchmarked off Treasury bills. The loan is priced according to a spread, which is added to the term of a Treasury note and which corresponds to the term of the loan. In other words, a loan with a 10-year term is priced by adding a spread to a 10-year Treasury note. Spreads are stated in what is referred to as basis points. A spread of 185 basis points is equivalent to 1.85 per- cent. If the 10-year Treasury is currently priced at 4.30 and the spread is 185 basis points, then the interest rate applied to the loan would be 6.15 percent.

The interest paid on borrowed money represents the cost of capital, so the higher the rate, the greater the amount paid. On a smaller loan of, let’s say, $100,000, a difference of 0.5 percent in the interest rate will have only minimal impact on the viability of an investment opportunity. On a larger loan of $1 million, however, the difference of 0.5 percent is much greater. When applying for a loan, you should make every effort to negotiate the best possible rate, especially on larger loans. I recently met with one of the lenders with whom my company  does business to review our financial statements from the previous fiscal year and to plan for the coming year. Since I do several million dollars’ worth of business with this lender each year, I don’t hesitate to ask for better pricing. I reminded him that our company works with several other lenders who are eager to earn more of our business. My expectation is that he will soon be giving me a call with more favourable pricing.

To help better understand the impact of various differences in changes in the interest rate. Using a real estate loan calculator, the effect of changes in interest rates can be examined on a base loan of $2.5 million. The loan spread matrix illustrates how changes in the rate affect changes in the monthly payments. With a loan amount of $2.5 million and a rate of 6.25 percent, the monthly payment would be $15,392.93. By reducing the rate by 0.5 percent, the payment is reduced to $14,589.32, which represents a monthly savings of $803.61 and an annual savings of $9,643.32 to the investor. The matrix allows you to quickly and easily examine the effect of changes in rate applied to different loan amounts at different rates.

Now let’s take a look at how the reduction in the cost of funds by 0.5 percent has affected the value of the property. We have already established the owner would save an additional $9,643.32 each year. This means that the income stream from the property will increase by that same amount. To capitalize the value of the increase in the income stream, we simply convert the cash flow to a single capital value, as follows:

Present value of income stream = Income / Capitalization Rate = $9,643.32/.08 = $120,541.5

In this example, a capitalization rate, or cap rate, of 8.0 percent was assumed. Converting the additional income in this example gives us a single capital value of $120,541.50, which is a  direct result of the reduction in the cost of funds by only 0.5 percent. Although it may initially seem that this would increase the value of the property, because interest payments do not affect NOI, the value of the property does not change. It does, however, affect the return on investment (ROI), since the added cash flow represents a savings to the investor, which in turn increases the rate of return. When you begin to understand the relationship between the real estate cost of capital and its effect on value and returns, you can then begin to take full advantage of its powerful and dynamic force. Remember that all it takes is a small change in the interest rate to have a dramatic impact on the rate of return. 

No related posts.

Got anything to say? Go ahead and leave a comment!