Loan constant
Also called Mortgage constant, Debt constant.
The loan constant is annual debt service divided by the original loan balance, expressed as a percentage. It combines the interest rate and the amortisation schedule into one number, which is what makes it the right rate to compare against a cap rate.
How it works
A borrower's actual cost of debt is not the coupon. A 5.75 percent loan amortising over thirty years costs about 7.00 percent of the balance every year, because principal is being repaid alongside interest. The loan constant is that combined figure, and it is the number lenders use for quick sizing.
Its main analytical use is positive and negative leverage. When the going-in cap rate exceeds the loan constant, borrowing raises the cash-on-cash return above the unlevered yield, which is positive leverage. When the constant exceeds the cap rate, leverage lowers the current return, which is negative leverage, and the deal is relying on growth or appreciation to compensate. Most of the low cap rate market of the last decade traded on negative leverage, which is a legitimate position but should be a deliberate one.
The constant falls as the amortisation term lengthens and rises as it shortens, so a thirty-year schedule and a twenty-five-year schedule on the identical rate produce meaningfully different coverage and different cash flow. On an interest-only loan the constant simply equals the interest rate.
Formula
Loan constant = annual debt service / original loan amount- Interest only: the constant equals the interest rate
- Amortising: the constant is above the interest rate, and the gap widens as the amortisation term shortens
- Positive leverage when cap rate > loan constant; negative leverage when cap rate < loan constant
Worked example
The sample property. $36,335,000 at a 6.35 percent coupon. Going-in cap rate 5.40 percent.
| Interest only, annual debt service | $2,307,272 |
|---|---|
| Constant, interest only | 6.350% |
| Thirty-year amortisation, monthly payment | $226,089 |
| Thirty-year amortisation, annual debt service | $2,713,072 |
| Constant on a thirty-year schedule | 7.467% |
The cap rate is 5.40 percent and the constant is 7.47 percent, so this deal is on negative leverage of 207 basis points once principal starts. Debt reduces the current yield and the return has to come from growth or from the exit.
The common mistake
Comparing the cap rate to the interest rate
A 5.40 percent cap rate against a 6.35 percent coupon looks like 95 basis points of negative leverage. Against the 7.47 percent constant it is 207 basis points, more than twice as wide, because amortisation is a real cash cost even though it builds equity rather than being an expense. Compare the cap rate to the constant, and remember that a loan structured with an initial interest-only period is on one side of that comparison at the start and the other side later.
Related terms
- Debt service coverage ratioThe debt service coverage ratio is net operating income divided by annual debt service. A 1.25x means the property produces $1.25 of income for every $1.00 of principal and interest owed, so net operating income could fall by 20 percent before coverage reaches 1.00x and the loan stops being covered.
- Cap rateA cap rate is a property's net operating income divided by its value or price, expressed as a percentage. It is the unlevered first-year yield on the purchase price and the standard shorthand for what a market is paying for a stream of property income.
- Interest-only periodAn interest-only period is a stretch at the start of a loan during which the borrower pays interest and no principal. It raises early cash flow and coverage, and it ends with a step up in debt service that has to be modelled.
- Cash-on-cash returnCash-on-cash return is a year's cash flow after debt service divided by the total equity invested. It measures the current income yield on the money actually at risk, ignoring appreciation and any eventual sale.
- Loan sizingLoan sizing is the process of determining the maximum loan proceeds a property supports. A lender runs three independent tests, a loan-to-value cap, a minimum debt service coverage ratio at a stressed rate, and a minimum debt yield, and lends the lowest of the three.
- Break-even occupancyBreak-even occupancy is the occupancy level at which a property's collections exactly cover its operating expenses and debt service, with nothing left over. Below it, the property consumes cash instead of producing it.
Every figure, traced to its source
Altyst computes these in exact decimal arithmetic, not with a language model, and clicking any number shows the formula behind it.