Posted almost 8 years ago

The Annual Loan Constant - What It Is And Why It's Important

Cash Flow is talked about ad nauseum on the boards.  However, few people ever give a precise or correct definition of cash flow.  John T. Reed has the best article on the internet about positive cash flow.  In it he describes two scenarios where you are likely to find a property with positive cash flow in the real world.  

 

The first of these scenarios is what engineering geeks like to call the trivial solution.  This case is when you have an abnormally low LTV on a property and "buy cash flow" by spreading a lot of equity in a project to make it spit off cash.  This is clearly nonsensical behavior.  The elegance of real estate is that one can take what is mostly a low yield product and apply sufficient leverage to it to have a nice ROE-bearing project.  

 

The second case where you get real world cash flow is when the capitalization rate exceeds the annual loan constant where the LTV ratio is normal.  Normal is generally 70-80% and represents what lenders look for to protect their security interest when they extend you credit to purchase a property.  

 

So what is the annual loan constant?  The annual loan constant is the total of both principal and interest payments on an annual loan divided by the loan balance.  For fully-amortizing loans the loan constant is higher than the mortgage interest rate because part of the ordinary annuity payment is used to pay off the loan in addition to paying on the principal.  

 

So why is this important and who cares?  The loan constant can be thought of as the "lender's capitalization rate" on their portion of the investment.  If you multiply the loan constant by the LTV percentage the resulting figure needs to be less than your capitalization rate to get positive cash flow.  A higher LTV will make this multiplication product higher and thus it is harder to achieve positive cash flow using the same underlying capitalization rate.  

 As an exercise pick some of the threads on the forum that discuss real world data for single family residences.  What you will find when you run the numbers is that the true capitalization rates for SFRs are roughly 3 - 6%.  Even with debt very cheap today it is not hard to see that the loan constants will be in the 5%+ range for investment property and thus for much of the SFR market you would need to put up a lot of equity to move the loan contant needle low enough to produce a positive cash flow via a low LTV.  

 

The devil is in picking great real estate product and that is not easy to do with a ton of competitors chasing SFRs every day of the week.  If you learn to outsmart those competitors and find the best deals you are still operating on razor thin margins from a cash flow perspective.  You will need to capitalize on the other real estate profit centers or move to more cash-flow-favored investments like multi-family product to achieve the passive income you are seeking.  


Comments (1)

  1. This is one of the best articles I've read on BP. This topic is not nearly discussed as much as it should. Do you normally calculate the loan constant using the PMT on excel?

    Ex:

    I/Y: 5%

    Term: 30 year

    PMT(5%,30,-1)

    =6.501%

    or do you have another way of calculating this? Also, is there an ideal spread between the Loan Constant and Cap Rate and/or any other metric?

    I appreciate your insight