Commercial Investment Real Estate September/October 2013 - Page 41

Lenders and investors see ROI differently. by Eric B. Garfi eld, CCIM, MAI Since the market crash f ve years ago, CCIMs and other com- mercial real re e estate professionals have been asked far too of en, “What is it i worth?” With a paucity of sales from which to extract investmen n benchmarks, many of us were limited to guesswork, investment mathemat t mathematics, or both. To add to our challenges, credit remained tight, forcing forci i a retreat of some lenders from commercial real estate all togethe together. e When f nancing was not at issue, some of us turned to mathemat- ics to expla a the market in a period without empirical transactions. explain (See “Cap p 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 capitaliza- tion rates. T e information may help us close more escrows in our ef orts to understand the plight of lenders. 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 mod- els inf uenced by mortgage and equity rates of return. T e Ellwood formula with its comprehensive algorithms gave way to a stream- lined 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 calcu- lation 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 f ow avail- able for debt servicing. T is is the Gettel formula. T e Gettel formula explains cap rates in a simplif ed fashion by examining a commercial real estate investment from the perspec- tive 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 projec- tion of, say, future depreciation or appreciation, he may feel justi- f ed in opting for this simpler method [debt coverage].” T e Gettel formula, which is also known as the debt coverage formula (T e 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 f nanced); 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 amortiza- tion 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 conse- quential from the lending committee perspective. September | October | 2013 39