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| Financing Component .0967 x .75 = 0.072503 |
| Equity Component .10 x .25 = 0.025000 |
| Capitalization Rate 0.097503 |
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. Or assume that you decide to sell the car at the end of four years, but when you request that the bank release the title, the bank demands a payment of $10,000. Their explanation is: "Sorry, but we don't take into consideration the principal portion of your loan payments. You still owe $10,000." This is how the Band of Investment handles the Financing Component. Although giving the appearance of accuracy, it does not correctly reflect financing and it produces erroneous results. |
Equity Component - Misleading and Incorrect
| The Equity Yield Rate is, by implication, analogous to the investor's rate
of return, or Internal Rate of Return. It is commonly used to represent
the investor's rate of return by both bankers and real estate professionals
who are not thoroughly informed on the subject. The Equity Yield Rate is not the same as the Internal Rate of Return or the Investor's Return on Equity. It must not be compared to the published rates of other investment vehicles; e.g. the Annual Percentage Rate of savings accounts or mortgage loans, bond yields, annuity yields, etc. The Equity Yield Rate is the investor's annual Cash on Cash Yield - the funds available to the investor after mortgage payments divided by his original Equity Portion of the investment. And this is only true if Net Income from the property is assumed to be constant; i.e. does not increase or decrease each year. And this is only true until the mortgage loan is paid off, at which time the annual Cash on Cash Yield goes up substantially. The cash on cash yield is an important consideration to the investor. He needs to know that there will be a positive cash flow after mortgage payments are made. But his required cash on cash yield will vary, depending upon the property. It should not be compared to other market interest rates or to the cash on cash yield requirements that were observed for other real property. For example, let's take two office buildings that are identical in all respects, except for the local market area. Market Area 1 is a suburban growth area where rents have been observed to be increasing each year. Market Area 2 is an urban market where rents are not expected to change. Common sense (and mathematical algorithms) tell us that the investor will accept a lower cash on cash yield (Equity Yield Rate) in Market Area 1 because he knows that his income will be increasing each year, resulting in an overall rate of return (IRR) that is higher than his initial cash on cash yield. The Band of Investment cannot account for this change in income. A layman's example Suppose that you are offered two investment alternatives. The first will pay you $1,000 per year for 10 years. The second will pay you $1,000 in the first year and the payment will go up by 1% per year in each of the next nine years. Which investment produces the highest rate of return for you? Which one will you choose? Obviously the second alternative is the best. But the Band of Investment calculation cannot tell you that and cannot quantify the difference. |
| Financing Component - Rate Attributable to Loan (.0967 x .75) = 0.072503 |
| Equity Component .10 x .25 = 0.025000 |
| Equivalent Band of Investment Rate 0.097503 |
| Less Equity Build-up 0.015122 |
| Indicated Capitalization Rate 0.082382 |
| Financing Component - Rate Attributable to Loan (.0967 x .75) = 0.072503 |
| Equity Component (14.7957 x .25) = 0.036989 |
| Equivalent Band of Investment Rate 0.109492 |
| Less Equity Build-up 0.011989 |
| Indicated Capitalization Rate 0.097504 |