Mortgage Mortgage Lender

Mortagagemortgagelender W Mortgage Mortgage Lender Mortgage Szh Category Dongfangcj Mortgage Mortgage Lender Mortgage Equity Technique - Real Estate Valuation

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  • The investor wants the Internal Rate of Return on his investment to equal 10%. To find the amount that he should pay, he would simply divide the net income produced by the investment (net income is assumed to be constant each year) by the yield which he requires. Assume a net income of $10,000.00.

    Net Income
    		 Capitalization Rate
    Required Yield
    APR
    IRR    		 Value
    $10,000 divided by .10 = $100,000


    To prove that his annual yield is 10%, divide the net income produced by the investment ($10,000.00) by the value of the investment ($100,000.00).

    $10,000 divided by $100,000 = .10 per annum

    In the example above, the required yield and the Capitalization Rate are the same. This method is sometimes referred to as Capitalization in Perpetuity.

    When There is a Loan
    If a loan is used to partially fund the investment, then the analysis must be modified in order to calculate the value of the total investment that will still produce a 10% annual return on the investor's cash investment. To simplify the discussion, assume that the loan is interest only, i.e., the investor is not required to pay back any principal as long as he holds the investment. Further, assume that he will be able to borrow 50% of the value of the investment and that he will pay an interest rate of 12% on all funds borrowed. The other 50% will be the investor's cash.

    In order to calculate the value necessary to give the investor a 10% return on his cash, we must calculate the amount that the investor will receive each year, after he pays the interest on his loan. The calculation is as follows:

    Step 1: 50% of value multiplied by 12% interest rate = .06
    Step 2: 50% of value multiplied by 10% required yield = .05
    Capitalization Rate .11


    The above example is a special case of the Band of Investment that is applied correctly because the loan is Interest Only. This will be proven below. The sum of Step 1 and Step 2, the Capitalization Rate, is equal to 11%. We divide the income produced by the investment ($10,000.00) by the Capitalization Rate (11%), in order to find the value of the investment.

    Net Income
    		Capitalization Rate
    		 Value
    $10,000 divided by .11 = $90,909.09

    To prove that the investor's annual yield is 10%, we first calculate the amount that the investor will receive after he has paid the interest on the loan.

    Net Income $10,000.00
    Interest paid (90,909.09 / 2 * .12) -5,454.55
    Received by the Investor 4,545.45

    Then we divide this remainder (the amount received annually by the investor) by the investor's cash investment ($4,545.45 divided by $45,454.55). The result equals 10% - the investor's annual yield.

    The Mortgage Equity Technique

    Discussed above is a simple example of what is often called the Band of Investment. It is a special case, where the Band of Investment is used correctly. It is also the beginning of what is known as the Mortgage Equity Technique. The simple examples described above, Capitalization in Perpetuity and Band of Investment, inadequately reflect most typical investments in the marketplace. In the marketplace, loans are usually amortized, requiring that principal as well as interest be paid each year. This additional payment reduces the cash that the investor receives each year. Also, as principal is repaid, the loan balance is reduced. This too, must be considered.

    The Mortgage Equity Technique was developed to build loan amortization and the value of the Reversion into the Capitalization Rate. An additional variable, the "holding period", was introduced into the Mortgage Equity Technique, recognizing the fact that an investment typically is not held forever. Now, instead of assuming that an investor's yield is received in perpetuity, the yield is received over a specific period of time.

    As a result of introducing a Holding Period, an additional factor, Equity Buildup, must be added to the calculation. To illustrate, we use the same assumptions that were used in the example immediately above. But instead of an Interest Only loan, we assume that the loan will be amortized over a period of 25 years. We also add the assumption that the investment will be held for 10 years - the Holding Period.

    In order to calculate the value necessary to give the investor a 10% return on his cash over the Holding Period, we must calculate the amount that the investor will receive each year, after he pays both principal and interest on his loan. The calculation is as follows:


    Step 1: 50% of value multiplied by 12% interest rate = .063193
    Step 2: 50% of value multiplied by 10% required yield = .050000
    Step 3: Calculation of Equity Buildup -.003841
    Capitalization Rate .109352

    The sum of Step 1 Step 2 and Step 3, the Capitalization Rate, is equal to 10.9352%. We divide the income produced by the investment ($10,000.00) by the Capitalization Rate (10.9352%), in order to find the value of the investment.

    Net Income
    		Capitalization Rate
    		 Value
    $10,000 divided by .109352 = $91,447.80



    HP 12C steps to calculate Annual Mortgage Constant - Step 1
    f REG Clear payment registers
    g8 Set payment to end of period
    1PV Present Value of 1
    12gi 12% Annual Rate divided by 12
    25gn 25 year term converted into 300 months
    PMT Monthly payment or monthly mortgage constant
    12x Convert result to Annual Mortgage Constant
    .5x 50% of value - Annual Mortgage Constant


    HP 12C steps to calculate Equity Buildup - Step 3
    Assumes HP registers above have not been cleared
    10gn Year that balance will be paid off - Holding Period
    FV Balance at end of 10 years
    1+ Displays amount of loan paid off after 10 years
    .5x 50% of value - Loan Ratio
    Interim Answer = .061218
    Sinking Fund Factor
    1.10 Enter 1 + Required Yield
    10 (yx Key) Raise 1.10 to power of 10 (holding period)
    1 - Interim Answer
    (0.10/x Key) Get reciprocal
    Sinking Fund Factor = .0627454
    .061218 x Calculate Equity Buildup factor
    Equity Buildup Factor = .03841

    Investment Analyst - The Advanced Mortgage Equity Technique

    As stated at the beginning of this discussion, Mortgage equity analysis has evolved over many years. The ready availability of desktop computers has allowed us to introduce complex algorithms into the Mortgage Equity Technique that permit us to recognize the other factors that influence an investor's actual IRR. In addition to Equity Buildup, the Advanced Mortgage Equity Technique that is used in Investment Analyst considers these additional factors.
    It is beyond the scope of this discussion to describe the algorithms used in the The Advanced Mortgage Equity Techique in depth, but this technique properly considers both the Financing Component and the Equity Component of an investment because it considers all of the factors that are ignored in the Band of Investment and the simple Mortgage Equity Technique.
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