What is the mortgage constant in commercial real estate loans?
The loan constant, also known as the mortgage constant, is the calculation of the relationship between debt service and loan amount on a fixed rate commercial real estate loan. It is the percentage of the cash paid to service debt on an annual basis divided by the total loan amount. Using the following formula, you can easily calculate the loan constant:
For example, a 20-year amortizing loan of $1,000,000 with a 6 percent interest rate would incur $85,972 in annual payments, and would lead to a loan constant of around 8.6%
$85,972/$1,000,000 = 8.5972%
The loan constant only applies to fixed rate loans or mortgages. In the event the interest rate is variable, there is no way to accurately predict the lifetime debt service on a loan, although it may be possible to calculate a constant for those periods of the debt's life that the interest rate is locked in.
Loan Constant vs. Cap Rate
One way to determine if a property's loan constant will make it profitable investment is to compare it against the property's capitalization rate, or cap rate, which can be determined using the formula below:
In general, a property that has loan constant higher than its cap rate will be losing money, a property that has a loan constant equal to its cap rate will break even, and a property that has a loan constant less than its cap rate will be profitable. For example, if the net operating income (NOI) of the property in the example above was $100,000 a year, it would have a cap rate of:
100,000/$1,000,000 = 10%
Since 10% is clearly higher than 8.6%, we can see that the example property is likely going to be at least somewhat profitable.