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Resolve Problems on Equity Dividend Rate and Property Investing

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Resolve Problems on Equity Dividend Rate and Property Investing

The equity dividend rate (we will refer to it in abbreviated terms as EDR) is a return measure that states the before-tax equity cash flow as a perentage of the equity investment. It is also referred to as cash-on-cash return. See here summary of the latest mortgage rate forecast.

This measure is often used in the case of property investments because the financing of property acquisitions involves in most cases the use of both equity and debt (borrowed funds).

Actually, investors using borrowing funds are advised to estimate the EDR, not only a simple overall income return, that does not take into account loan payments and the distinction of investment cost to loan and equity. The formula for calculating the EDR is:

EDR = BTECF / Equity investment

where

BTECF = Before-Tax Equity Cash Flow

Equity Investment = Total Investment Cost – Loan Amount

In the case of property investments that are partially financed with borrowed funds, BETCF refers to the equity cash flow, that is, the income the investor receives net of debt service (loan or mortgage payments). Within this context, the BTECF for a property is calculated as:

BTECF = Net Operating Income - Debt Service

Example of Equity Dividend Rate Calculation

To demonstrate the calculation of EDR consider a property investment with a total acquisition cost of £1,000,000 with an annual NOI of £100,000, and a £700,000 mortgage loan used for financing the acquisition. The loan was obtained with a 6% interest rate and a term of 20 years, which implies an annual debt service of £61,029.19 (if it is repaid annually). With these figures we can calculate the BTECF as:

BTECF = 100,000 – 61,029.19 = £38,970.81

Equity Investment = 1,000,000 – 700,000 = 300,000

With these two figures at hand we can now estimate the equity dividend rate as:

EDR = 38,970.81 /300,000 = 12.99%

Problems of the Equity Dividend Rate

The equity dividend rate has serious limitations as a measure of return of a property investment. The most important one is that it ignores potential changes in net operating income and property value in the years subsequent to the year that this measure is calculated. Just to give an extreme example in order to demonstrate this point, consider the case that the property has a large lease representing 70% of the total leasable space, which is expiring in the next year and has a contract rate significantly above market rents. When this lease expires and the tenant renews at market rents the NOI of the property and, therefore, its EDR will drop significantly. If the tenant does not renew and the space remains vacant for some time before a new tenant is found the reduction in NOI will be even greater. The point is that any of these two developments will reduce significantly the cash flow of the property but this will not show since the EDR is calculated using the current NOI of the property. In addition to any changes in the NOI of the property, the investor may realize capital gains or losses depending on how cash flows and cap rates will move, but none of such potential gains or losses can be captured by the EDR.

The other problem with the EDR is that it fails to account for the income tax implications of the investment, which may alter drastically the ultimate return delivered to the property investor.

A more complete and comprehensive methodology for estimating the return on a property investment is the discounted cash flow model

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