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.
CCIM.com
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.
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