DID YOU KNOW…
The term “yield” was historically used to depict bushels of grain or sacks of potatoes
when agriculture ruled.
NET PROFIT MARGIN
ASSET TURNOVER
LEVERAGE
NET INCOME AFTER TAX
EFFECTIVE GROSS INCOME
= ROE
EQUITY
When the results of these three components are multiplied, the resulting number is equal to the number arrived
at by using the basic formula of I / E = ROE. The DuPont
model is very telling because it allows you to determine
what portion of an ROE calculation is coming from efficient operations, lease income or financial leverage. When
making a decision between two alternative investments,
knowing to what extent your ROE is a product of financial
leverage or leasing and efficient operations, is critical.
Yet another income rate is the mortgage capitalization
rate (Rm), also referred to as the mortgage constant. A
mortgage constant is the ratio of one year’s total mortgage
payment to the mortgage balance. The mortgage constant
tells you what annual rate is required to amortize a dollar,
using monthly payments at any specific interest rate and
term. The formula is as follows:
ANNUAL LOAN PAYMENT / LOAN BALANCE =
MORTGAGE CONSTANT
DISCOUNT RATES
Discount rates reflect a return over the entire term of an
investment. The term “discount” also means yield. Therefore, a discount rate is a yield rate. A discount rate refers to
any rate used to convert future income into present value.
The term “discount” comes from the expectation that the
present value will be always be less than the future value.
A yield rate is a rate of return on capital. The term “
interest rate” specifically refers to a yield rate on debt capital.
The terms discount rate, interest rate and yield rate
are synonymous and are used interchangeably. One of
the most popular discount/yield rates used in real estate
finance is internal rate of return (IRR). IRR is also referred
to as equity yield (Ye). Simply put, IRR is the rate that
makes the money coming out of an investment equal to
the money that goes into the investment. It is the rate that
makes NPV equal zero.
CAPPING IT OFF
Often, people ask, “If interest rates rise or fall, do cap
rates correspondently rise or fall?” The answer is simple:
There is no direct correlation between interest rates and
cap rates. Interest rates are yields on debt capital and are
discount rates. Overall cap rates are income rates and
constitute the ratio between one year’s NOI and sale price.
Notice that interest rates on debt capital secured by
commercial real estate are generally the same nationwide,
yet overall capitalization rates typically vary from a low of
5 percent to a high of 10 percent on property types and
from city to city as economic conditions unfold.
Refreshing your knowledge on the basics of income and
discount rates will increase your proficiency in profitable
real estate analysis. n
Eric B. Storey, CCIM, CPM ( eric.storey@zionsbank.com), oversees the management, leasing and acquisitions of
properties for Zions Bank in Utah and Idaho.
