BAND OF INVESTMENT
Despite advanced calculation tools like Investment Analyst, it is still
a common practice today to develop a capitalization rate using the Band
of Investment. Unfortunately, it is one of the principle methods still
taught and relied upon in the real estate community. It is also widely
used by real estate professionals to support a capitalization rate. While
this method gives the appearance of accuracy because it is mathematically
correct, it falls short in many important respects. Factors that are not
considered in this method are:
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Other Topics
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- Equity Buildup
- Costs in addition to the nominal equity (nominal equity is the Value less
loan amount)
- Changes in the value over the life of the investment
- Changes in annual income over the life of the investment
- Selling Expenses incurred upon sale of the property
- Holding Period - BOI assumes that investment is held in perpetuity
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:
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| 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 |
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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:
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"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"
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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
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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.
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| Financing Component .0967 x .75 = 0.072503 |
| Equity Component .10 x .25 = 0.025000 |
| Capitalization Rate 0.097503 |
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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.
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.
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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
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