Q. How are investment property lenders arriving at maximum loan proceeds when underwriting today’s historically low cap rates? A. Carefully, very carefully! Capitaliza-tion - or cap — rates are at historic lows, and while capital stays abundant, interest rates stay low and there is minimum speculative construction, it is likely that they will stay historically low for a while. Cap rates differ for the various levels of risk associated with different property types and geographical location. I am being told from lenders active in the southern California market that cap rates under 6 percent are being recorded for most transactions. That is not the case in southern New Hampshire, but I was involved in a recent transaction locally where a more than 252-year-old apartment complex traded at less than a 6.5 percent cap rate in an arm’s-length, all-cash transaction. Today’s low cap rates are challenging to lenders and investors alike and present additional risk considerations when leveraging investment real estate. There are many differing cap rates, but from a literal perspective a cap rate can be any rate that will convert income into a value. The typical cap rate formula is value=income/capitalization rate. Simply stated, a cap rate is the annual return on cash flow (NOI) assuming an all-cash (no leverage) purchase price. A 7.75 percent cap rate applied to a $77,500 NOI would support a $1 million purchase price. Capitalization theory is a very deep subject and is one of ongoing study and debate in the appraisal industry, which is generally responsible for utilizing cap rates to opine on real estate values. In general, cap rates have historically tracked interest rates and other alternative investments, such as Treasury bonds and commercial paper. These alternative investments are considered generally safe and easily traded while investment real estate is considered to have varying degrees of risk and not so easily traded. The additional return requirement for this risk is the basic theory behind a cap rate needing to be greater than the return rates for other safer alternatives. The amount of risk also varies for alternative real estate investments. For example, the likelihood of receiving the projected NOI from a property leased for 15 years to a AAA-rated company is perceived greater than receiving the projected NOI from a neighborhood retail center with six local businesses on three- and five-year leases. Local businesses are historically more likely to fail or relocate, creating vacancy and a greater risk of receiving the anticipated NOI. Investors apply a greater value for the less risky income stream and a lesser value for the more risky income stream. Assuming the potential NOI to be the same for the above two properties, the cap rates would likely be different to reflect the risk variation. How much those cap rates differ is left to the individual investor, who will acquire each property. Lenders are challenged with trying to match competitive financing terms with the values that individual investors assign to the varying degrees of risk. This is a more difficult process for lenders in historically low or high cap rate markets. The early 1980s, in comparison, would be the opposite type of market that exists today, since interest rates and cap rates were at historic highs. In those days, the prime rate exceeded 20 percent vs. 5.5 percent today and you were able to invest in a one-year certificate of deposit at a rate of 12 percent or better. What would a real estate investment have to trade at to attract capital away from a 12 percent CD? Lenders are concerned with many issues when financing investment real estate, but from a pure economic perspective, they must be satisfied that the current cash flow will support the repayment of the loan. Additionally, lenders will analyze whether the outstanding loan balance at loan maturity can be refinanced under the loan terms likely to be prevalent at that time, which, of course, one can only speculate on. The low cap rate that the investment is trading at today will not likely be the same cap rate at loan maturity, especially if the loan term is five years or longer. Assumptions for future loan terms and cap rates often are a consideration when the lender quotes today’s loan terms. A specific example of how a lender might look at underwriting a property being traded at a 7.75 percent cap rate will be provided in next month’s article. David B. Eaton, president of Eaton Partners, Manchester, manages the firm’s Commercial Mortgage Group. Questions can be submitted to him at Commercialnotes@eatonpartners.com.