Band of Investment Method to Determine Interest Rates

Band of Investment Method to Determine Interest Rates
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Band of investment (BOI) constitutes a financial method of calculating the capitalization rate, or cap rate, of a property. This method employs a handful of important figures, among them interest rates expected by investors in real-estate purchases. BOI employs assumed interest rates, percentage of invested capital and other figures when determining a cap rate. Although many financial sources rely on BOI as the preferred method of calculating cap rate, other sources decry its purported deficiencies.

Understanding Capitalization Rate

Cap rate, usually expressed as a percentage, constitutes a method of converting income earned from a property into an expression of capital value. Cap rate calculations sometimes involve simple math. In some instances, a cap rate equals nothing more than the Net Operating Income (NOI), or annual profit of a property, divided by its cost.

For example, if a property cost $1 million with a NOI of $100,000, it maintains a cap rate of 10 percent, or 100,000/1,000,000 = .10. This means it earns 10 percent of its cost each year. The BOI method attempts to calculate the cap rate on a property for investors by considering equity and financing investments.

Band of Investment Interest Rates

Calculating a cap rate using the BOI method involves the use of interest rates on financing/mortgage investments and equity investments. Equity investments constitute the amount of an investment made in cash, while the mortgage component considers the value of a loan against the financed value of a property and the mortgage rate.

Generic BOI calculations use standard interest rates on each component, generally assuming a return of about 10 percent on a mortgage investment, and 12 percent on an equity investment. These assumed rates go into calculating weighted rates of return, which lead to the cap rate on an investment. In real situations, accountants calculate cap rates using return percentages stipulated by contracts and mortgages.

Calculating Capitalization Rate Using Band of Investment

Calculating a cap rate using the BOI method entails the use of three mathematical processes, one for determining the weighted mortgage cap rate, one for determining the weighted equity cap rate, and another for determining the overall cap rate. Weighted cap rate equals portion of purchase capital x rate of return.

For instance, assume an investment apportioned as 75 percent mortgage and 25 percent capital, and return of investment rates at 8 percent on mortgage and 12 percent on equity. The weighted mortgage cap rate equals six percent, or .75 x .08 = .06, and weighted equity mortgage cap rate equals three percent, or .25 x .02 = .03. Adding these cap rates gives the final cap rate via BOI, in this case 9 percent, or .03 + .06 = .09.

Drawbacks of Band of Investment

Some people find serious deficiencies in the BOI method, due to the overall simplicity of its calculations. Some believe the financing/mortgage component of BOI makes erroneous assumptions, such as ignoring that mortgages last for a predetermined length of time, and aren't indefinite.

The component is also criticized for ignoring differences between principal and interest. The equity rate, meanwhile, uses the equity yield rate, not internal rate of return or investor’s rate or return, creating misleading figures. It is also important to point out that BOI also ignores taxes, which impact cap rates.