Question

One of your Client wants to buy a Rental Property, with estimated Net Operating Income (NOI) for the next year of 80,000, using a (L/V) Ratio of 85%, amortized at a Mortgage Rate of 6.5% over 25 years. Your Client wants to have a Return on Equity (ROE) of 12%. You have decide to use a Band of Width Investment Method to estimate the Cap Rate and then apply this Cap Rate to Calculate Value of the Rental Property. According to your Calculation, the Value of the Rental Property is approximately is:

	a.	$ 921,000
	b.	$ 583,000
	c.	$ 700,800
	d.	$ 727,300

Answer 1

Cap Rate = F+E

Here F = Financing component

E = Equity component

Calculation of Financing component:-

the Financing component means annual mortgage constant multiplied by the loan to value ratio

Annual mortgage constant:-

Annual mortgage constant = 12 * i / [ 1 - ( 1 / (1+i)n )]

Where i = annual interest rate divided by 12 = 6.5%/12 = 0.54167%

n = term of loans in months = 25 years *12 = 300 months

Annual mortgage constant = 12* 0.54167% / [ 1 - ( 1/ (1.0054167)300)] =12* 0.54167% / [ 1 - ( 1/ 5.56197844)]

= 12* 0.0054167 / [ 1 - 0.197777071] = 0.065 / 0.802222929

Annual mortgage constant = 0.08102486

Financing component = Annual mortgage constant * loan to value ratio

= 0.08102486 * 85%

Financing component = 0.06887113

Calculation of Equity Component :-

Equity component means is the investors required equity yield rate multipled by the equity value rato

Equity to value ratio = 100- loan to value ratio = 100 - 85 =15%

Equity component = 12% * 15% = 0.12 * 0.15 = 0.018

Calculation of cap rate :-

Cap Rate = F+E

Here F = Financing component

E = Equity component

Cap rate = 0.06887113 + 0.018 = 0.08687113

Cap rate = 8.687%

Calculation of the Value of property :-

Value of Property using cap rate = Net operating income / Cap rate

=80,000 / 8.687%

Value of property = $ 920,916.31 = $ 921,000 (approximately)

option A is correct