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I'm trying to work out some Financial Management Rate of Return (FMRR) calculations for practice and I was curious if there are some industry standard variables to use.

Here are some assumptions I'm making at the moment. I know each situation is different but this is just for practice.

  1. Inflation at 3%
  2. Closing costs at 1.5%
  3. Reinvestment rate of 7.5%
  4. Loan-to-value ratio of 80%
  5. Yearly appreciation of 3%
  6. Yearly cost increases of 3%
  7. Yearly rental increases of 3%
  8. Tax rate of 28% (should I include state?)
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Where possible, I would use current data or historical averages. Many of these values will vary quite a bit between years, states, etc. so your mileage may vary.

Here are some values specific to Financial Management Rate of Return calculations:

  1. The safe rate - I think there is some confusion here, since a lot of definitions state this as the rate at which money could be invested in a highly liquid and safe investment. Given the current low interest rate environment, interest rates, T-bill rates, etc. are essentially 0. This doesn't mean that you use a rate of 0, however. When discounting, you're trying to capture what a sum of money in the future is worth in purchasing power today (or in some previous period). For this, use inflation. See point 1 below. For example, if someone in 1950 gave you $1,000, that might be quite nice, but if they offered to give you $1,000 in 50 years, it wouldn't buy nearly as much. Although FMRR isn't my specialty, I think it makes sense to use the rate of inflation as the safe rate.

  2. The risky rate/reinvestment rate - This is the rate of return you could earn if you invested your money in an intermediate or long-term investment. The risk is higher because the money isn't as liquid, and obviously, because you're earning more return, you have to take on more risk. If you don't mind glossing over volatility, you could use the average rate of return on the S&P 500, which over the past hundred years has been around 9%. Anywhere from 5% to 9% is fine for practice. I tend to be conservative in my return calculations, so I would also take into account inflation here by subtracting it from the risky rate before discounting by that rate. (I can explain the math behind that in another question, if necessary).

For the remainder of your values, I would once again use as realistic data as possible.

  1. The current inflation rate is about 1.5%, so that's one option, but 3% is a standard assumption for the US and is certainly fine for practice. If you need something better, pull the CPI data I linked to and run the calculations.
  2. Average closing costs are about 1.88%, although this varies across states, mortgage contracts, and time.
  3. Reinvestment rate - see above.
  4. 80% is probably fine for a LTV. Duca, et al. (2011) have a nice paper that estimates the average loan-to-value ratio for 1st time home buyers at around 90-95% in 2008, which would probably be considered a high LTV. Anywhere in the range 70%-90% should be fine for practice calculations (and from a research perspective, if the data supports it).
  5. According to the Census, the price of new homes increased by about 5.4% from 1963 to 2008. Since the housing boom, this has almost certainly changed, but for practice calculations, it's certainly fine. The Case-Shiller index of home prices increased by about 3.4% (roughly), and the National Association of Realtors states that existing home prices rose by around 5.4%. Keep in mind that this doesn't account for a change in home size, inflation, etc. and like I said, these figures will have changed in recent years.
  6. I'm not sure if you're talking about the increase in the cost of living, but if you are, inflation will certainly suffice in practice. See point 1.
  7. I seem to remember hearing that 3% is the national average, but this varies depending on a) the landlord's discretion, b) the laws in the jurisdiction, e.g. rent controls, tenants' rights, etc., c) my potentially faulty memory.
  8. 28% is probably fine, although you can look up specific average tax rates and make your decision based on that. I wouldn't include state unless you have a specific state in mind, but if you have a specific state in mind, many of the other averages need to be revised because they can vary significantly across state lines.
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  • John, thanks so much for your comments. One thing I neglected to add was that this is for a commercial property, but your information is useful just the same. In the end I'd like to get the After Tax Cash Flow FMRR, or Return on Equity. This is the process that I plan on using: SGI -Vacancy = EGI - Operating Expenses = NOI - Debt Service = Cash Flow Before Taxes + Amortization - Depreciation = Taxable Income - Taxes = Cash Flow After Taxes What are good "safe" and "risky" rates? 5% and 10%? I'm really rusty on the tax part, is the basis still Sales Price - Adjusted Book Value? – Moi May 9 '13 at 7:56
  • And how do I add line breaks??? heh – Moi May 9 '13 at 7:56
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    @Moi Too many questions there. A) For safe/risky rates, are you talking about the risk-free rate on T-bills? That's about 0.01% now, so effectively 0. Otherwise, I don't know what you're referring to. B) I don't know about the tax basis for property or the rest of your calculations. Not being an accountant, it isn't my forte. You could ask a separate question like "how do I calculate basis of a commercial property?" and you may get more help. – John Bensin May 9 '13 at 11:09
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    @Moi For line breaks, press [Enter] twice. You can also use a numbered list like I did. If you click "edit" on your question, you can see the markdown that I used to make the list. You rarely need to use HTML tags in a question/answer, so if you find yourself doing so, you may want to try a different tactic. Once you see the markdown (or use the buttons at the top of the question/answer box), click Cancel/Discard to stop editing. – John Bensin May 9 '13 at 11:10
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    @Moi I presume you're still talking about Financial Management Rate of Return calculations, right? Careful with the acronyms, since FRMM isn't the same as FMRR. See the first section of my updated question for specific information about estimated safe rates vs. risky rates. – John Bensin May 9 '13 at 20:10

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