What is a Sinking Fund Factor? Purpose and Formula!
Over the course of owning residential or commercial real estate property, real estate investors typically can expect to make some capital expenditure to the property if they hold it long enough.
In order to plan for this anticipated future capital expenditure, real estate investors will typically start setting aside money in a reserve account in order to insure that they have the suitable amount of money available to cover the expense when needed.
This reserve is known as a sinking fund.
Okay, but rather than setting aside a lump sum amount anticipated to replace say, a roof in five years, the real estate investor generally would prefer to create a sinking fund to which he or she can start depositing an annuity payment with compound interest at regular equal intervals.
The idea, of course, is straightforward.
The investor wants to avoid shelling out the money up front. Foremost, he or she might not have the funds readily available, and secondly because the investor has chosen not to heavily deplete the rental property’s cash flow for any given year to cover the capital expenditure.
As a result, the investor instead opts to set aside the future required funds gradually over the course of time until the time the funds for the expenditure are actually needed.
Sinking Fund Factor
The sinking fund factor is the calculation that tells the investor how much of an annuity payment that must be made each conversion period at a given rate of compound interest to have available that specified sum at some given future time period
For example, we’ll say that the real estate investor is anticipating a cost of $30,000 in five years to replace a roof on an office complex he or she owns. Moreover, the investor feels it reasonable that he or she could make regular payments at the end of every three months into an account yielding 7% annually.
The sinking fund factor would be used by the investor to calculate what each quarterly payment would have to be in order to accumulate the $30,000 required in five years.
The photo below illustrates one method how the investor make that determination very quickly without even knowing the formula.
If the real estate investor starts making regular quarterly annuity payments of $1,243.97 into an account that yields an annual rate of 7% he or she will have the desired $30,000 required in five years to replace the roof on their office complex.
We have provided the formula for the sinking fund factor for your learning.
Be warned, however, that computing for a sinking fund is pretty complex because it involves time value of money computations. We certainly suggest you use a solution like iCalculator to make the calculation for you, but only throw that out so you know that there are resources.
About the Author
James Kobzeff is a real estate professional and the owner/developer of ProAPOD - leading real estate investment software solutions since 2000. Create cash flow, rates of return, and profitability analysis on rental property at your fingertips in minutes! Learn more at www.proapod.com
ProAPOD also provides iCalculator - an online real estate calculator that enables you to learn dozens of real estate definitions and formulas as you calculate. You save 64%. Learn more at real estate calculator
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