Appraisers' Free Forum

What the hell is a mortgage constant and why do I need to know what it is?

Mortgage constant, also called "mortgage capitalization rate" is the capitalization rate for debt. It is usually computed monthly by dividing the monthly payment by the mortgage principal. An annualized mortgage constant can be found by multiplying the monthly constant by 12, or dividing the annual debt service by the mortgage principal.

A mortgage constant is a rate that appraisers determine for use in the band of investment approach. It is also used in conjunction with the debt-coverage ratio that many commercial bankers use.

The mortgage constant is commonly denoted as Rm.

The Rm is higher than the interest rate for a fully amortized loan because the Rm includes consideration of the principal as well as the interest. The Rm could be lower than the interest for a negatively amortizing loan.

Okay, thanks Bill. I understand where a commercial appraiser could use that information to help them with their calculation of NOI.
As a residential, my personal opinion is why?
Sigh. I am learning more by the moment.

It represents the rate at which you receive a return OF capital as well as ON capital (i.e., your profit.) In other words, it's the payment on the loan, without considering amounts escrowed for insurance and taxes. The "PI" portion of "PITI."

You need to know it because that's the amount represented by Rm in the formula Ro=Rm+Re. For example, you've got a property with conventional financing. Purchase price is $100K. To build a cap rate using the weighted average (a.k.a. "band of investments") method, you survey local banks and find out that they'll finance up to 70% of the selling price at 6.75%; The longest they'll lend for is 20 years. Surveying local investors and extracting rates from the market shows the local equity rate (cash-on-cash return) (equity dividend rate) to be 12%. In other words, if you can't get at least 12% on the money you actually have invested, then it isn't worth the trouble.

So, your cap rate is composed of (30% x 12%) plus (70% x 6.75%), right?

Not so fast, Bubba. That 6.75% represents the bank's return ON capital. What about the return OF capital? To figure that, use your HP12C to figure out the payment due on $1 at 6.75% for 20 years. Go ahead: 20 g n; 6.75 g i; -1 PV; PMT = 0.00756, if you've got it set to the beginning of the period. Otherwise, 0.00760. That's per month. Multiply it by 12 for the annual rate. In a spreadsheet, use the PMT function like this: =12*PMT(rate/12, years*12, -1,,1) (and watch those two commas in that formula!). So your mortgage financing rate is 6.75%, and your mortgage constant is 9.073%. Quite a difference.

But now you can build your cap rate: (9.073%*.70)+(.12*.30) = 9.95%

General rule of thumb for logical test of results is that the mortgage constant should be about 3% above the mortgage rate. If there's a large divergence, check and double check your numbers and methods.

As a residential, my personal opinion is why?

Because a *certified* residential is allowed to do 1-4 family units, and knowing this may get to be important. Gross income multiplier is a bit coarse.

Also, in my jurisdiction (TN), a Cert Res can do small commercials up to $250K transaction value.

Sorry, I was composing my reply above while Bill was posting.

Not a problem, Jim or Bill. Truthfully, since I rarely do income, I've never had a need to know this stuff, but as I work on my practice tests and my homework for the upcoming class, it is becoming more and more clear how this could and is applicable to income properties. It is becoming obvious that the way I've seen them done is not the proper way, and that this is a valid, if overlooked, part of appraising incomes.