Discounting and Determining Yield

Yield can be defined as the income return on an investment and is usually quoted as a percentage or more precisely, annual percentage. Basic yield calculations are very simple.  To calculate yield, you simply divide the amount of the income you receive by your cost of acquiring the investment.

Ex:  Bill purchases a duplex for investment.  The cost of the duplex is $120,000 and he earns $1,000 in monthly rent from each tenant for a total of $2,000 per month or $24,000 per year in total rent.  To calculate the “yield” on Bill’s duplex investment, simply divide the annual income he receives ($24,000) by his investment cost $ of $120,000.

So in the case above, Bill’s gross yield on his investment is 20% (before taxes and costs of maintenance)

Yield on a Term Note

Yield on a term note is calculated exactly the same as above.  If you were to purchase a note due in 5 years for $120,000 whose payments were $2,000 per month (interest only), your investment yield would be 20% per year for 5 years.  At the end of the fifth year, you would receive your $120,000 back.

Yield on an Amortized Note

Yields on amortized notes, such as those found with the typical mortgage, are much more difficult to calculate.  This is because of the fact that each “blended” payment made on a mortgage contains a portion which is principal payback.  The word “amortization” comes from the Middle English word amortisen which means “to kill”.  So, a blended payment (one made up of both principal and interest), will eventually pay off the note over time or kill it.

Since the holder (investor) of the note is receiving a portion of the investment back each and every month, the amount of the investment is less and less over time.  It is not a constant such as that found in a term note.  The actual dollar payment received each month, however, remains exactly the same.  Such complex calculations of amortized yield must be performed on a financial calculator.

Understanding Discounting

Discounting is a method of yield enhancement and represents an “inverse relationship”.  That is to say, on an investment with definable payment stream, the less you must pay for that investment, the greater your investment yield.  Let’s take a look at a few simple examples using Bill’s duplex.

Bill’s investment yield with a purchase price of $120,000 was 20%.  But what if Bill was able to pay less for the duplex.  What if he could talk the seller into taking a discount of $10,000 and buy the duplex for $110,00 instead of $120,000?

By negotiating the $10,000 discount, Bill’s yield on investment is greater, rising to 22%.  He is getting more for his money.

What if Bill is an EXPERT negotiator and manages to purchase the duplex for just $100,000 (taking a $20,000 discount)?

By taking a discount of $20,000, Bill’s investment yield has risen to a whopping 24%.  So you now understand the inverse relationship between price and yield.  The less paid for an investment with a fixed or definable payment, the greater the yield to the investor.

The above example is the basis for investing in the discount note industry.  Mortgage note investors will purchase mortgage notes at a “discount” to face value to increase their yield or profit.  To calculate discounts and their effects on yield when it comes to amortized mortgages, you must learn how to use a financial calculator.  But don’t worry…we’ll teach you how a little later in this course!