The loan constant is annual debt service divided by the loan amount, expressed as a percentage. It states the full annual cost of borrowing, interest and principal together, in the same unit as a cap rate, which is what makes the two directly comparable.
Loan constant=Annual debt serviceLoan amount
- Annual debt service
- Twelve monthly payments of principal and interest, at the loan's rate and amortization.
- Loan amount
- The original principal, not the current balance.
- Compare it to the cap rate, not to the interest rate. The rate alone leaves out principal, which is most of the difference on a short amortization.
- When the constant is above the cap rate, leverage lowers the cash return and the case for borrowing has to come from somewhere else.
- Longer amortization lowers the constant without lowering the rate, which is why the schedule is worth negotiating.
- Principal inside the constant is not a loss. It is return that cannot be spent until a sale or a refinance.
The same $1,012,000 loan at 6.5% over 30 years, beside the 6.0% cap the property was bought at.
That gap is why the building earns 6.0% and the equity earns 3.3%. The loan is not free money here; it is a drag being paid for with time.
Related terms
All termsLeverage
Leverage is using borrowed money to control a larger asset than cash alone would buy.
InvestmentCash-on-Cash Return
Cash-on-cash return is the cash a property puts in the owner's pocket in a year, divided by the cash he actually put into it.
FinanceAmortization
Amortization is the schedule by which a loan is repaid through level payments that cover interest first and principal second.
Terms arrive with the writing.
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