Could you help me to explain in reading Income property analysis- Bank of investment method,
Why do we have to adjust the capitalization rate by adding a sinking fund factor? as an example on Kaplan note, we have to plus sinking fund factor to annual mortgage cost but i do not know the reason why we have to do that. If not, what is the mistakement?
Thanks so much!
can you post the example they give, thanks
Dear Andrew, here is the example: Assume you are estimating the value of a property that is financed 60% with a 15-year first mortgage and 40% with equity capital. The interest rate on the mortgage is 7% with monthly payments. The required cash on cash return on equity capital is 14%. Compute the market capitalization rate. Answer: The capitalization rate to be used under the band-of-investment method, R0(BOI ), is the weighted average cost of the individual capital components: (mortgage weight × mortgage cost) + (equity weight × equity cost) The annual mortgage cost is the annual interest rate plus a sinking fund factor. The sinking fund factor in this case is the future value interest factor of an annuity of $1 at 7% per year compounded monthly for 15 years (the parameters of the loan). Using your financial calculator, it can be calculated as: N = 15 × 12; I/Y = 7 / 12; PV = 0; FV = –1; CPT → PMT = 0.00316 × 12 = $0.0379 I don’t know why to add sinking fund on this example. Could you help me? thank you so much!
I was curious about the same thing - from what I read, it looks you are adding a small payment each month which goes into a reserve fund and is used for capital improvements. It appears that nobody uses this method anymore when valuing CRE.
Is anyone able to replicate the calculator functions listed? I’ve tried changing the P/YR and C/YR to 12 and I still can’t get the answer provided. Thanks.
please never do the P/Y and the C/Y change
do a 2nd TVM on your TI BA II Plus
and enter the numbers as above.
I got the same answer as they have in the example.
Sinking Fund factor is to account for the payment of both part of the principal and the interest for the year.
That corrected the problem. Dividing the annual rate by 12 made me think that everything needed to be on a monthly basis. Thanks for the help.
So why don’t we see/use this more often? I realize it doesnt apply for most corporate debt bc it’s nonamortizing, but that’s not always the case. What about private companies that do typically have some sort of amortizing loan…I’ve never personally adjusted the cost of debt for this nor does CFAI really consider it outside of real estate relates instances. Why not more often?
If I include sinking fund factor to create an annuity to return the $1x principal back to the lender, does it mean that at the end of my lending period (15 years), my property has a salvage value of $0? Why would I invest in such real estate property?
Am I missing something here?
Essentialy Sinking find factor is to take care of depriciation in property - so that lender can be adequately compensated for reduction in value of collateral. It is applicable to one of methods for capitalization fund but in practice, It can be applied to any collateral - with depriciating value.
Sinking fund provision simply states how much should I must put aside above the interest on the debt, thus at the expiration of the loan you will be able to refund the face value of the bond (debt).
try this formula to make things easier:
Mortgage Constant = interest rate + SFF
= (Monthly payment * 12)/principal
Understood. Other than the formula, my stated question was
“If I include sinking fund factor to create an annuity to return the $1x principal back to the lender, does it mean that at the end of my lending period (15 years), my property has a salvage value of $0?”
rockmania, the mortgage constant is the interest rate you are paying on the debt, so if you take out $1 million for 20 years at 8%, with monthly payments, what interest rate are you paying? Is it 8%? No it isn’t. For this loan, you are paying about $8364 per month, multiply that by 12, and you see that you are paying about $100,360 per year, which means the correct interest rate you are paying is about 10.04%, and that’s what matters when you try to value your property.
Thank you Dreary.
My bad. I was thinking in terms of the residual value of the property, after the loan is fully amortized. That has nothing to do with the WACC.