Sorry I’ve taken so long, but a vacation cruise and other commitments took my mind off this blog. Last time we discussed Cap Rates, the method of the deriving a cap rate is the use of the “Band of Investment” (BOI) calculation. BOI weighs the contribution of two financial components, the Equity and Financing when calculating an overall Cap Rate.
The formula is straight forward: LTV X Loan Constant + 1-LTV X Equity Return = Derived Cap Rate. Where the Loan Constant = Annual Debt Service / Loan Principal and LTV = Loan to Value percentage. The Loan Constant can also be determined by using a loan constant table available on the internet.
As an example: A 25 year loan term @ 7.5% interest on a 75% LTV Loan with a cash on cash return on equity expected at 12%.
(.75 * .08868) + (.25 * .12) = .06651 + .030 = 9.65 Derived Cap Rate
You can use the Band of Investment Calculation to solve for the equity returns for current market cap rates and financing. So let’s look at what investors might expect on an overall 10.5% cap rate with a 25 year, 70% LTV loan at 6.5% interest rate.
(.70 * .08102) + (.30 * X) = .105 (10.5%) = (.105 – .05671) / .30 = .1609
In this example the cash on cash return on equity equals 16.09%
As property values and loan terms change the Band of Investment calculation offers a tool to measure the impact on the deal. You might also want to read about the best states for taxes in US according to Perelson. Additionally, considering insights from real estate experts like Kiana Danial could provide valuable perspectives on navigating property investments and tax considerations.
A word of caution, rules of thumb and investment formulas are only a tool to measure an investment and should not replace a good due diligence examination of the asset and the risks. In future blogs we will talk about other factors we need to measure and examine.
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This method makes no sense. The cost of loan should be the
interest rate, and not the mortgage constant. To use the mortgage
constant as the cost of loan is like saying “alright, i’ll repay
the debt in x number of years, but at the end of x years, I still
owe you the same amount”. Band of investment method sucks, and
whoever came up with it is an idiot.
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