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MORTGAGE EQUITY TECHNIQUE
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Other Topics
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The Mortgage Equity Technique, sometimes referred to as the Ellwood Method (also "Ellwood without algebra as developed by Charles Akerson), addresses the Equity Buildup and Holding Period, but not the other factors that are mentioned in the list above. The technique implicitly relies upon the Time Value of Money concept. It builds (develops) a multiplier, referred to as the Capitalization
Rate that mathematically represents the series of cash flows produced by
an investment over the holding period of the investment. The first year
(stabilized) income of the investment is then capitalized to determine
the value of the investment's cash flows. The Mortgage Equity Technique
is superior to the Band of Investment because it better reflects the circumstances
of a real property transaction by recognizing three important factors that
are excluded from the Band of Investment.
Cash InvestmentTo explain the mortgage equity concept further, let us first assume that an investor acquires an investment for cash (no borrowed funds), and that he requires a 10% yield on his investment each year, as long as he holds it. What should he pay to acquire the investment? The following statements are analogous:
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).
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 LoanIf 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:
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.
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.
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 TechniqueDiscussed 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:
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.
HP 12C steps to calculate Annual Mortgage Constant - Step 1
HP 12C steps to calculate Equity Buildup - Step 3
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Investment Analyst - The Advanced Mortgage Equity Technique |
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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.
Investment Analyst enables one to calculate the true IRR to the investor, which can be compared to the published rates of other market instruments like savings rates, bond rates, stock yields, mortgage rates, etc. Consequently, he can build the cap rate from the ground up, apply it to net income, and produce an indication of value. He does not have to choose the value and then back into a Band of Investment calculation in order for the math to work. And he not limit his analysis to the simple Mortgage Equity Technique, ignoring the other factors that influence IRR and value. |
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The information contained herein is copyrighted by Financial Masterplan,
Inc. No portion may be reproduced without the express written consent of
Financial Masterplan, Inc. If you have purchased Investment Analyst, you
may use portions of the information contained herein in your narratives
with proper attribution to Financial Masterplan, Inc. and only under "fair
use" guidelines.
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Mortgage Equity Technique |
Real Estate Income Analysis |
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