PAYMENTS IN ADVANCE (ANNUITIES DUE)

Rents are paid in advance that is, they are paid at the beginning of the lease period and for each rent period after that.. For example, if a building is leased at monthly periods, the lessee must pay the landlord one month's rent on the first day of occupation and on the monthly anniversary of that date until the end of the lease period. Therefore, investors in real estate enjoy an advantage over other investments such as bank deposits where the interest is paid at the end of the period that is, "in arrears".

If the period is monthly or weekly and the interest rate is low, such adjustments to the valuation equation are small enough to be ignored in practice because errors in the rest of the valuation equation far outweigh any error caused by not taking into account these two factors. Further, if the capitalization rate has been correctly analyzed from comparable sales and adjustment for that advantage is built into the analyzed rate.
On the other hand, if the rent is being paid quarterly, half yearly, or yearly and interest rates are relatively high, then such an adjustment should be made.

Another school of thought is that the adjustment should be made any case because it is easily included in the valuation calculation particularly when computer spreadsheets and financial calculators are used.

ADJUSTMENTS FOR ANNUITIES DUE

Financial calculators have an annuity due key for this calculation for example, the <2ndF>+<BGN/END> keys on the Sharp EL 735. The advantage of an annuity due investment is that the lessor can invest the rent payment for one period. Therefore, the adjustment is to increase the nominal rent by the opportunity cost of investment for one period.

EXAMPLE

Current rent: 1 000 per month

Interest rate: 1% per month

AA = AD * (1+i)

Where:

AA = annuity in arrears

AD = annuity in advance or annuity due

i = interest rate as a decimal.

AA = 1000 * 1.01 = 1010 per month.

Therefore, 1010 per month in arrears is equal to 1000 per month in advance. All calculations and values can now be determined by using
1 010 instead of 1 000 per month.

EXAMPLE

Determine the market value of the above investment property at 8% per annum nominal:

MV = NAI * 100/CR
MV = 1010 * 100/(8/12) = 151 500

Note that a monthly capitalization rate is used instead of the annual rate.

ANALYZING SALES

The capitalization rate analyzed from comparable sales can be determined with annuities due instead of the more common method, annuities in arrears as shown in the following example:

EXAMPLE

Sale price: 100 000

Net monthly rent: 1 000

Interest rate: 1% per month

Adjusted capitalization rate:

CR = NAI/SP * 100

Where:

CR = capitalization rate

NAI = net annual income adjusted for annuities due

SP = sale price

CR = (1000 * 1.01)/100000 * 100 = 1.01% per month
= 12.12% per annum nominal.

What is the effective annual rate?

See nominal and effective interest rates