File this under, “no dumb questions” please but when but taking the often used 1M park purchase as an example, I’m hoping someone can help me understand the debt service in relation to the three-point spread.
1M purchase price at 8% cap
80K NOI
200K down
800k at 5% = 40k year
CoC 40k/200k = 20%
So my question is what about the principal on the loan? How do you best model this (what assumptions should I be conservatively making?) Are buyers seeing amortization schedules of 20, 25 years?
Of course such a loan will be a amortized loan and therefor will be paid down over time. But keep in mind that some of the 20% cash on cash will be in the form of principle pay down and not spendable money in your pocket.
Most people refer to CoC as the actual cash that goes in your pocket (post debt service, ie principal is not counted). IRR is better measure to capture bigger picture over time.
The piece of the puzzle that you are missing , is the loan amortization term ( could be 15 years , could be 30 years). then you can can go to google and run an amortization schedule, and figure out how your principal and interest is paid out.
Then you can model a sale or refinance event and you will have a bench mark to calculate your principal balance ( depending on say if its year 5 or year 10). This will give you an idea of what your principal was paid down.
Also know if the loan comes with a balloon as that can be a risk factor ( more so variable that you need to be aware of ) .
Also, your model has a 5 point spread which may not be realistic. You have assumed a 10% cap rate and 5% interest rate on the loan.
CoC does not include principle pay down, as that is not cash. CoC is cash flow after financing, divided by the TOTAL cost of purchase (down payment, loan origination fee, closing costs, initial reserves, initial repairs, legal, accounting, nitial travel, inspections, etc.)
At least hats the textbook definition.
I modeled this. 3 point spread rule is approximate. A 3 point spread at higher cap rates will give your greater cashflow than at lower cap rates.
At 5% interest, 25 am, 75% ltv, a 20% COC return is at 10.5 CAP
If you factor in principle paydown, its at a ~9 CAP
So from what the numbers look like to me, it should be the 5 point spread rule, with today’s interest and CAP rates.