Debt Service Decoded: Navigating the Numbers in Investment Real Estate

Written by Michael J. Rohm, MAI, CCIM, R/W-AC

July 15, 2024

Transitioning from a full-time appraiser to a dual role in sales and appraisal has introduced me to conversations with buyers and sellers that I wouldn't have experienced otherwise.

Whether appraising or providing broker opinions of value, my combined experience offers clients an advantage in making assumptions and understanding implications on highest and best use, buyer profiles, and valuation constraints.

In the appraisal/valuation space, we’re primarily concerned with probability of certain assumptions coming true and it’s incredibly important for us to understand how our assumptions affect probability. The most critical assumption in an investment property valuation is the capitalization rate, which is the focus of this article.

Many in the CRE industry—appraisers, salespeople, buyers, sellers, and lenders—typically view the cap rate as an input. They take the net operating income (NOI), divide it by the cap rate, and use this calculation to estimate the property value.

However, my experience in sales has shown me that the cap rate is more accurately viewed as an output. It’s determined by the debt structure assumptions and debt service coverage, which are driven by the property's cash flow.

Although cap rate can be a useful tool, we need to understand what assumptions were made for the net operating income that the cap rate is applied to. The list is possibly endless, but the below table highlights NOI assumption differences that influence the implied cap rate variability.

As you can see, no two (2) capitalization rates are created equal.

Therefore, when extracting cap rates from the market, it may be more useful to understand the relationship between anticipated Year 1 NOI relative to T -12 NOI as well as the debt structure that was used to acquire the property.

Employing variable underwriting assumptions allows for a more comprehensive view of value and buying power, in an effort to reconcile, apply, and explain capitalization rates.

Cap Rates Are an Output, Not an Input

We’re to the point that I need to defend my statement on cap rates being a result of debt assumptions. Let’s take a look at the below pro forma…

Now, let’s analyze different debt structures to determine whether a suggested list price and/or value conclusion of $2,500,000 is reasonable and what the conclusion really implies in terms of necessary debt structure to make the deal “pencil”.

The above chart attempts to convey the debt structure constraints necessary to yield a value at or near $2,500,000.

In theory, the preliminary value conclusion of $2,500,000 is derived from an iterative process based on the relationship between market-oriented debt structures and current performance, as well as sales of similar properties – keeping in mind the probability of each scenario occurring.

It’s great to analyze different possible scenarios to set expectations for a seller or to check your suggested list price for reasonableness, but at this point we need to micro-analyze the most likely buyer profile and attempt to mirror their debt assumptions:

Scenario 1 is most consistent with local and regional lender loan terms. If the property size isn’t large enough for an institutional buyer, this is likely the debt structure that needs to be given most weight. This structure requires a buyer to bring 40% of equity to the table to “pencil” at approximately $2,500,000. This is a financing constraint that may be difficult for most buyers to overcome depending on their cash on cash yield requirements.
Scenario 2 is most consistent with an aggressive local or regional bank – probably with a pre-existing relationship with a borrower. This scenario should be closely considered with Scenario 1 if the deal size is relatively small.
Scenarios 3 and 4 are most consistent with agency financing, i.e. Freddie and Fannie debt. Agency debt typically applies to larger complexes but can be assumed for as little as five (5) units. To qualify for agency financing, property must meet certain criteria, borrowers must have a solid credit history and demonstrate financial stability, experience in owning or managing multifamily properties is often required, and specific net worth and liquidity requirements must be met. Therefore, Scenarios 3 and 4 are more speculative and least probable for a 20-unit apartment complex but may still apply in certain circumstances.

Now, let’s take a look at a different NOI scenario where we assume a 10% increase in NOI without capital expenditures. This may be from marking below market leases to market, reducing operating expenses, or both. All assumptions remain the same with exception to loan- to-value.

You can see that the debt structure constraints necessary to yield a value at or near $2,500,000 become more favorable to a buyer. Required equity is reduced for all four (4) scenarios and the “implied” cap rate also becomes more favorable as we’re assuming that we can increase NOI in the near term with nominal amounts of risk.

The question we need answered to determine if $2,500,000 is a reasonable conclusion is whether buyers and lenders will rely more on pro forma than in-place performance. Between 2020 - 2022, lending on pro forma was more commonplace.

From approximately Q1 2023 to the date of this article (July 2024), it is increasingly difficult to sell a lender on a business plan with assumptions for rapidly increasing rents and decreasing expenses relative to historical
performance. Not to mention that availability of capital is also very low relative to 2020 - 2022.

So, if we conclude that in-place analysis is more credible, let’s pick the most probable scenario.

For me, it’s Scenario 1 in the first chart. This analysis requires a buyer to bring 40% equity to the table to make the deal pencil at approximately $2,500,000. What if we move the LTV to 70%?

Increasing the debt placement to 70% LTV translates into an implied value of roughly
$2,100,000 with an associated cap rate of 8.07%.

Depending on the asset, this is a very real outcome despite what many salespeople or appraisers might tell you about where multifamily cap rates are right now. Therefore, it’s vitally important to analyze the property’s potential in conjunction with the most likely buyer profile and the associated debt structure that a buyer will employ.

Understanding the constraints of debt structure on value is crucial for sales professionals.

The key takeaway is recognizing which offers to reject or counter based on financing contingencies that can't satisfy a 1.20 debt service coverage ratio (DSCR). By running a thorough analysis, you can identify acceptable financing contingencies, reducing re-trades and ensuring a higher probability of closing at the stated price.

Given the above, DSCR analysis is king for valuations where the most likely buyer will be placing debt on the property; therefore, it's important to understand that cap rates are essentially an output of how buyers are financing similar deals.

Weaknesses of Cap Rate

One major weakness of cap rate is that it’s not always a relevant metric for value-add or heavy
value-add property valuations.

Buyers are referring more to yield on cost until stabilization in these scenarios.

Each investment strategy has differing risk profiles and stabilizing costs which is why investors typically give more weight to yield on cost.

Secondly, there’s an inherent conflict of interest in the market when reporting cap rates.

A salesperson or broker is incentivized to report a lower selling cap rate to draw attention to the sale and get more listings as a result of it.

Conversely, a buyer is incentivized to report a higher acquisition cap rate to report to their investors and appear more competent. How each party arrived at NOI is typically impossible to determine but important to understand when attempting to draw conclusions from the transaction.

Finally, some buyers make acquisition decisions with more emphasis on relationship to replacement cost than in-place financial performance. This philosophy holds that since it is increasingly difficult to make financial sense of new construction, an imbalance of supply and demand will translate to higher rental rates and higher valuations. Not to mention the historic spread between cost of homeownership and the cost to rent as of July 2024 which suggests significant “room to run” on the multifamily rent side.

Cap rates for these transactions tend to be less reliable as acquisition basis was the procuring motivating factor. In these cases, the sales comparison approach may be more applicable than an income approach – especially in the current market where in-place cap rates are difficult to make sense of despite headwinds from interest rates and availability of debt capital.

Why It Matters

As listing agents, we can leverage this insight to set realistic expectations for sellers.

As buyers’ agents, it helps us understand deal constraints, allowing for better-informed offer structures.

For cash buyers, including those involved in 1031 exchanges, these analyses ensure that we're not overpaying for a property beyond what the typical market can support.

From an appraiser's perspective, the traditional approach stops at analyzing NOI without considering debt service assumptions. While cap rates are applied to NOI, understanding how monthly mortgage payments align with market-oriented debt service coverage factors is essential for a comprehensive view of an income-producing asset.

This was a blind spot for me before my transition into sales, and it likely is for many appraisers, regardless of their
experience.

I urge both the brokerage and appraisal industries to incorporate debt service coverage ratio analysis as a reasonableness check to contextualize value conclusions more effectively.

We must understand the financing constraints we’re assuming when placing a cap rate on a certain income stream. This will help us set better expectations for all parties involved in a transaction as well as assist us with serving our clients to a higher standard.

Michael J. Rohm, MAI, CCIM, R/W-AC, is a fee appraiser and real estate agent working throughout Pennsylvania.

He is president and owner of Commonwealth Commercial Appraisal Group and is director of valuation advisory and senior associate with Landmark Commercial Realty. Contact him at mrohm@commonwealthappraiser.com.

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