A Mortgage "Cap Rate"

Explain "cap rate", what is it and how is it arrived at. Also, how does the "cap rate" fluctuate in relation to the price/value? Is it inverse, as the "cap rate" goes up the price/value goes down, and vice versa? Is that right? Why? Thank you

2 Answers

The term **"cap rate"**is usually used in conjunction with an Adjustable Rate Mortgage or ARM.  Interest rates have nothing to do with property values.  An ARM typically will have an annual cap and a lifetime cap.  [Hybrid ARMs, such as a 5/1 ARM have an initial cap which is usually equal to the life cap].  There are several things that come into play with rates on an ARM.  The first is the initial rate on the loan.  Often there is a discount for the first year, sometimes referred to as a 'teaser' rate.  There is also an Index, which is not controllable by the lender, which is used a the base of calculating rate adjustments.  There is a Margin, which is set by the lender at the outset and cannot be changed during the time of the mortgage.  The margin is added to the index to arrive at an actual rate.  Often, it will be rounded up or down to the nearest 1/8%.  And finally, the adjustment caps, which often are 2%/6% for a typical ARM.  The first number refers to an annual adjustment cap on the note rate & the second refers to a maximum upward adjustment in the rate during the life of the loan.

The terms are spelled out in the note and adjustable rate rider that is recorded with the mortgage.  Let's use an example.  If your ARM has an initial rate of 4.5% with caps of 2 & 6, it means that the first adjustment [up or down] will range between 2.5% and 6.5%.  It means that the maximum rate ever would be 10.5% no matter what the math of adding the margin to the index tells us.  Let's say that you have a margin of 2.75% and the US 1 Year Treasury Index being used stands at 3% at the time of signing.  In 12 months, if the index remains unchanged, the math says to add 3.00% [index] and 2.75% [margin] to arrive at the new rate.  The math says 5.75%.  Since your start rate was 4.5%, 5.75% is within the acceptable range of the cap of 2% increase/decrease.

If the index was 4.00%, the math tells us the new rate would be 6.75%.  But that rate exceeds the maximum annual cap, so the rate for year 2 would only be 6.5% instead of 6.75%.

As stated earlier, the value of the property has no bearing on how caps on an ARM work.

I think you are referring to mortgage equity capitalization rate, which is a method of valuing income property that takes into account financing considerations.

The method is frequently used for analyzing real estate investments, because most of these are financed to the hilt and the financing really drives the return on your investment. However, even in all-cash deals, the technique is effective in estimating the value of an investment.

To explain the mortgage equity concept further here's an example:

A buyer acquires property for cash (no borrowed funds), and she requires a 10% yield each year for as long as she holds it. What should she pay for it?

To find the value of the property, simply divide the net income produced by the investment (net income is assumed to be constant each year) by the yield required.

So if the net income for the property is $10,000, you divide it by 10% (your desired yield) and you get $100,000. Easy.

When there is financing, things change a bit.

If a loan is used to partially fund the investment, then your calculation get a little more involved.  Let's make it easier by financing with an interest-only loan. Assume that 50% of the property is financed and the interest rate is 12%.

In order to **calculate **the value necessary to give the investor a 10% return on her cash, we must calculate the amount that the investor will receive each year, after she pays the interest on her loan. The calculation is as follows:

Calculate the annual amount necessary to repay loan interest (Step 1)

Calculate the annual amount necessary to pay 10% to investor each year (Step 2)

Step 1: 50% of value multiplied by 12% interest rate = .06

Step 2: 50% of value multiplied by 10% required yield = .05

Capitalization Rate .11

Now divide the $10,000 net income by the cap rate of 11%. You get $90,909. So that is what you want to pay for the property if you finance 50% at 12% and want a 10% return.

If your financing could be obtained at 10%, your cap rate drops to 10% (.05 + .05) and the value returns once again to $100,000.

You are correct, as you can see, the value goes down as the cap rate goes up. Because if your required yield doesn't change but your expenses increase you have to pay less for the property to get the same return.