Ok, this is part of the CFA curriculum that typically doesn’t get studied a lot because people think they know it implicitly. Well, I was in the mortgage business for five years, and get tripped up here time and time again. ____________________________________________ First, you need to calculate a capitalization rate. There are three testable ways to do this. 1. Market Extraction Method. Easy, just NOI/MV 2. Band of Investment Method. This only works with comparables that are mortgaged at the same loan to value (have the same debt/equity mix). You add a sinking fund factor to the cost of the mortgage, which is: i / 1+(i^n)-1 where i = interest rate on mortgage and n = number of years in mortgage Add the sinking fund factor to mortgage cost, and calculate WACC to find the cap rate. 3. Built-Up Method. Don’t just think you can add risk premia. You need to know WHAT risk premia to add. Take the pure rate (Risk free rate like in CAPM) + liquidity premium + recapture premium + risk premium __________________________ Now, with that said, you can calculate your Cap Rate. But, how do you calculate the value of the property? There are two ways. 1. First, derive the Gross Income Multiplier = Sales Price of comparables / Gross annual income of comparables Second, take the gross income of your subject property / Gross Income Multiplier to get Market Value. ***This will yield an upwardly biased price because it only incorporates gross income not costs, whereas the Direct Capitalization Approach uses Net Operating Income. 2. Direct Capitalization Approach = the same as the above but with Net Operating Income instead of Gross. __________________________________ Next, you can analyze cashflow returns by using the IRR method. This is helpful is you have to surpass a hurdle rate required by a group of investors. 1. IRR Method. Treat each annual Cashflow After Tax as CF1, CF2, CF3…CFn on your BA II Plus calculator. Treat the After tax Equity Reversion as the Terminal Nonoperating Cashflow (remember to add the CFt to that number when putting the data in your calculator!). Input the cap rate as your I/Y, or a “hurdle rate” and solve for IRR.
thanks. I will be studying this material today.
The annoying part is remembering which building produces more cash flow, which building is suitable for what type of investor, blah blah bullshit bullshit…
I don’t think we need to know how to calculate the sinking factor … correct? At least thats what I remember from the Schweser video, can someone confirm please.
I think you do, I saw one in the sample test, I would know it, besides it’s the same formula as calculating the EAA approach for project replacement w/ unequal lives in corp finance, just multiplied by 12…
Ignore sinking fund…it’s the same as 12*monthly payments/principal…it doesn’t get any easier than that.