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Age Mortagagemortgagelender Admin Categories Php Login Php Mortgage Mortgage Lender Band of Investment - Real Estate Valuation

Age Mortagagemortgagelender Admin Categories Php Login Php Mortgage Mortgage Lender


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While it is possible today to quantify each of the above components, the Band of Investment lumps them into one number - the Equity Yield Rate of the investment. Consequently, the true rate of return is hidden.

Because the Band of Investment is so commonly referenced in the industry, we display a Band of Investment Equivalent Calculation under the Cap Rate tab of the Analyst Worksheet and reference the BOI Equivalent Yield Rate on the Summary tab. In this calculation we calculate the required equity yield that must be used in the BOI calculation in order to produce the same capitalization rate that Analyst produces.

The advantage of Analyst is that it considers all of the factors that comprise the capitalization rate: mortgage payments,equity buildup, Soft costs/Closing costs, changes in value, changes in annual income, and selling expenses when the investment is sold.

Required IRR
Most importantly, in Analyst you can specify a true Required IRR that can be compared to other investment vehicles - bonds, stocks, savings accounts, annuities, etc. The Equity Yield Rate in the Band of Investment bears no relationship to the actual rate of return that an investor can expect, and it SHOULD NOT be compared with the yields of other investment vehicles.


Band of Investment Calculation
The Band of Investment is a yield capitalization method that is used to build a capitalization rate using just two components; financing and equity. The formula is:

Cap Rate = F + E where:

F = Financing Component
E = Equity Component

The formula is usually shown in this format:
Financing Component
Equity Component
Capitalization Rate

The Band of Investment method was an early attempt to mathematically quantify the factors that comprised a capitalization rate. Before computers became widely available and Capitalization Theory was fully developed, the tools to perform this calculation were limited. The best one could do was account for Mortgage Financing (by reference to payment tables and later using the HP 12C) and the investor's required yield (simple math).

The Financing component is the Annual Mortgage Constant multiplied by the Loan to Value ratio. The Equity component is the investor's Required Equity Yield Rate (This is NOT the same as the investor's rate of return or IRR. Please read the Required IRR paragraph earlier in this discussion) multiplied by the percentage of cash equity. For example, lets say that the typical terms for the property that we are analyzing are as follows:

Loan to Value Ratio: 75%
Mortgage Rate: 7.5%
Term of Loan: 20 years-paid monthly
Required Equity Yield Rate: 10%
Cash Equity Percentage: 25% (100% - 75% LTV)

Given the above, we can build a capitalization rate using the Band of Investment.

First, we must calculate the Annual Mortgage Constant or look it up in a mortgage payment table. The Mortgage Constant is also known as the Partial Payment function:

"the level periodic installment that will pay interest and provide full amortization or recapture of an investment of one in a given number of periods with interest at the given rate per period"


HP 12C steps to calculate Annual Mortgage Constant
f REG Clear payment registers
g8 Set payment to end of period
1PV Present Value of 1
7.5gi 7.5% Annual Rate divided by 12
20gn 20 year term converted into 240 months
PMT Monthly payment or monthly mortgage constant
12x Convert result to Annual Mortgage Constant


Algebraic formula for Annual Mortgage Constant

Annual Mtg.Constant = 12 * i / (1 - (1 / (1 + i) ^ n))
where: i = annual mortgage interest rate divided by 12
n = term of loan in months


Note that in both the HP 12C steps and the Algebraic formula, the monthly payment must be multiplied by 12 in order to arrive at the Annual Mortgage Constant.

The Annual Mortgage Constant for a loan with a 7.5% interest rate and a 20 year term is .
0967. Once we have this factor, we have enough information to build a cap rate using the Band of Investment.

Financing Component .0967 x .75 = 0.072503
Equity Component .10 x .25 = 0.025000
Capitalization Rate 0.097503

Band of Investment Summary
The Band of Investment attempts to reflect the financial circumstances of a real property transaction. It purports to account for the two elements of the transaction: Financing and Equity. However, it fails to achieve its objective because it ignores critical factors that must be considered, if one is to truely reflect the financial circumstances of a real property transaction.
Financing Component - Erroneous Assumptions
First of all, only part of the mortgage financing transaction is considered. In the example above, payments over the 20 year term are accounted for, but these payments are comprised of both principal and interest. The principal portion of the payments (called the Equity Buildup) will be returned to the investor when the loan is paid off, either at the end of the mortgage term or when the property is sold. Equity Buildup is not considered in the Band of Investment, although it has a significant impact upon the investor's return. The Financing Component accounts for the investor's annual cost, but does not consider the return of principal sometime in the future.

Second, the structure of the Band of Investment assumes that both the Financing Component and the Equity Component exist in perpetuity. That is, the mortgage payments never end and the investor never sells the property. The former assumption is erroneous. The mortgage payments end in 20 years in the above example. The second assumption is unrealistic. The investor will sell the property at sometime in the future. Or his heirs will inherit it.

A layman's example
Suppose that you purchase a car for $10,000 and finance the entire amount for a term of four years. You make payments for four years and assume that no more payments are due. The loan has been paid off and you can start to put the extra cash in your pocket. Right? But on the first of 49th. month, you receive a letter from the bank stating that loan payments are expected to be made for as long as you own the car.
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