Return On And Return Of Investment

[Stephen J. Vertin MAI]

I want to quickly add an extraordinary assumption. My question assumes neither income or value are level. We know that a capitalization rate can have both return on and return of investment. But according to everything I have read to date it appears that a yield rate always includes a return of and return on investment (whether it is positive or negative), it still exist.

Ergo, cap rates can have return on and of investment...when required but it seems yield rates must always have return on and return of investment (expect when both income and values are flat as stated in the extraordinary assumption). Any feed back is always important to me so please feel free to comment.

This is really an important question to me but some of the research is unclear.

 

[Terrel L. Shields]

The old $3 rule.
I want a $1 for $1 return of my money.
I want a $1 return on my money.
I want $1 for taking the risk.

Building a Hoskold like sinking fund, basically adds a safe (TBill rate) + 3 x the T Bill rate as a risked rate. Then capitalizes a steady income over the life of the project assuming no reversionary value, such as a mine extracting at a given rate.

 

[Gobears81]

Yield rates tell more of the story of the actual projected return than cap rates. The difference could most simply be broken down to growth. A cap rate may imply a 0% equity rate in a band of investment model, which could be inferred as implying return of but not return on investment, but that is based on a stabilized, near-term NOI projection. Unless the buyer has atypical motivations etc, that 0% equity rate speaks more to future growth projections. That is why yield rates are lower than cap rates when growth is negative and higher when growth is positive

 

[Michael P Jacobs MAI]

I want to quickly add an extraordinary assumption....

So sorry, I'm coming down with something and nowhere near prime, but feel compelled to write anyway. First, did I miss why any of this needs to be an extraordinary assumption, and second only a cap rate is return of and return on... in a DCF you get "return on" through the discount rate but have to add the (discounted) reversion to get the "return of." Ah-choo.

 

[Stephen J. Vertin MAI]

So sorry, I'm coming down with something and nowhere near prime, but feel compelled to write anyway. First, did I miss why any of this needs to be an extraordinary assumption, and second only a cap rate is return of and return on... in a DCF you get "return on" through the discount rate but have to add the (discounted) reversion to get the "return of." Ah-choo.

Michael thank you for your input. It is always appreciated. This is from the 14th and are actual footnotes to my above comments.


[1] While a real estate capitalization rate can also have a return of and return on capital a yield rate has few choice, (bar level income and value) to do anything but provide a return of and on capital simply due to its math ( R=Y- Δa). Further according to The Appraisal of Real Estate 14th edition p 455 “The rate of return on capital is analogous to the yield rate or the interest rate earned or expected. A typical example is the mortgage loan calculation in which the return of and the return on capital are considered in the level mortgage payment over time. Again only level values and payments remove yield rates from providing the return on and the return of capital.

Ibid p454

Ibid p455

Ibid p456

Ibid p457

Ibid p461

Ibid p510

Ibid p521

Ibid p563

 

[leasedfee]

Stephen,
I think it depends on what you're looking at. For a conventional overall rate, Michael's description is what I agree with. Boiled down to its simplest, Ellsworth's R is DCF. Getting a little deeper, the overall cap rate is a "compression ratio" of all of the information contained in the DCF model. Restated, the overall cap rate, as a compression ratio, reflects everything the buyer believes. For general investment properties the cap rate reflects just the normal stuff including renewal probability, rollover vacancy, general vacancy, inflation, yields, and reversion cap. It also includes H&BU changes, demolition, and capital repairs -- but this may be pushed far out in time and discounted to insignificance.

The you get into the Property Model: flat, exponential, straight-line. And they vary.

For a mortgage rate, simple flat interest rate would be the return on the principal at the incremental compounding point in time with a balloon being the return of. For fully amortized loans, the APR or mortgage constant would be the return on and of, because the payment is being amortized over a time period with $0 FV. You can break apart the mortgage constant to the discreet time periods to find out a amortization table/curve of which part is the of and which part is the on. Continuous exponential compounding (e.g., compounding an infinitesimal at every millisecond) gives you a formula for a curve.

Land, however, is perpetual. So the yield rate and the cap rate (R_L) would be entire a return on. This concurs with Classical rent theory.
(There may be practical exceptions where land is a deteriorating asset like farmland erosion, salting-up, and mineral extraction. Then you get into Hoskold/Im-whatshisname).

 

[Michael P Jacobs MAI]

... Further according to The Appraisal of Real Estate 14th edition p 455 “The rate of return on capital is analogous to the yield rate or the interest rate earned or expected. A typical example is the mortgage loan calculation in which the return of and the return mortgage capital are considered in the level mortgage payment over time.

Harumph... is the 14th Edition based on the "new new" math my 9 year old was learning? ("...these two ways of calculating 10+7 are essentially the same although one answer is 17 and the other is 20."). My summer cold is worse this morning so I'm not going to dig out my 8th and 10th editions, but Hal Smith MAI ETC would have marked me down had I answered a discount rate has elements of return on AND of investment. Unless definitions have changed, it simply can't be true that there is any amortization in a discount rate. I'm pretty sure we did the math back then frontwards, sideways, backward and inside-out so that we would never make this arguement. lol ""but I could be wrong, I sometimes am" as my wife has taught me to say.

 

[leasedfee]

Stephen,
Here is where it gets more interesting for me. There is a land component and a building component. The 13th TARE dropped residual analysis. In contrast, the 10th TARE had a great residual model where you could extract the land capitalization rate (R_L) from an overall rate (R_O). It is basically a Band of Investment /Akerson model.

We buy land. We buy buildings. In each location they vary. Sometimes greatly.

In Los Angeles, a warehouse's overall cap may be 5.0% to 5.5%. How do they get so damn low? Start to break things apart and you realize that 50% or more allocation ratio is towards the land. Land requires no return of the investment, so the overall rate incredibly low. The H&BU use is very near land value; you're only marginally buying a building; you're mostly buying land yields.

In contrast, in GoBear's rust belt markets, land value is nominal, so the overall rate is mostly building rate (R_B). In GoBear's severely depressed sectors, the H&BU may be to board up the building in 10-20-30 years once the interim use has been consumed. Thus your R_O is mostly R_B, being a return on and of, followed by nearly zero% (rounded) reversion. It takes on a Hoskold/Imwood premise, so you get escalating R_O with the R_B's on and of plus a sinking fund factor (1/S_n), which is both of and on. His yield to the building (Y_B) should be "normal" but the consumption process makes the overall rate (R_O) really high. Sometimes high cap rates are attributed to "high risk", but I tend to think it is the market's pricing of the direction of income and the on and of capital. . . . . You can see this in the regional differences in bonded/absolute triple-net long-term lease market, like Walgreens, Adv Auto Parts, 7-11, Dollar General. In the rust belt, the reversion after the lease's eventually expiration will drop, and it is priced in 100-400 BPs for the reversion.

 

[Elliott]

I think you can want any rate you want, but the market will tell you what rate you get, and it is essentially factoring in all the aggregate and micro influences.