Mortgage Constant

The mortgage constant is a year of loan payments, principal and interest, divided by the loan balance. At 7.25% over 30 years it is about 8.2%. Cap rate minus the mortgage constant is the test for positive leverage, and cash on cash return is where the result shows up.

The constant runs above the interest rate on an amortizing loan because principal is included: about 6.4% at 5%, 7.2% at 6%, 8.0% at 7%. An interest-only loan's constant equals its rate.

When a property's cap rate exceeds the constant, every borrowed dollar earns more than it costs and cash on cash rises above the all-cash return. When the cap rate is below the constant, every borrowed dollar loses a little and cash on cash falls below it. On the default deal an 8.0% cap rate against an 8.2% constant is slightly negative leverage, which is why 25% down returns 6.3% while all cash returns 7.7%.

Further reading: Mortgage Constant on Wikipedia.