Calculating an Average Annual Capital Growth Rate

The annual capital growth variable has a significant influence on the calculation of investment return, probably more significant than any other residential property calculation variable. It is therefore imperative that careful consideration should be given to the level of growth estimated in the calculation and that various scenario's should be measured against one another in order to reach a prudent financial decision.

We would however like to emphasise the importance of considering all variables which have an effect on the investment return achieved from a residential property investment - our aim is simply to highlight the importance of the annual capital growth variable and to provide guidance with the calculation.

The residential property market, like any other investment market, can be subjected to volatility at times and it is therefore not recommended to simply use a current average annual capital growth rate to forecast investment return. The current average annual growth rate should however play an important role in the assumptions used to calculate an average annual capital growth rate over the entire intended investment period.

The current growth rate can be based on house price data released by financial institutions on a monthly basis and estimates can be based on the movement in house prices. There are a number of residential property indicators released in the media, for example ABSA's house price index, Standard Bank's residential property barometer and ooba's price barometer - our preference is the ABSA house price data because of the number of years this measurement has been released and the volume of transactions included in the data (historical ABSA House Price Index data can be found here).

Once a benchmark has been established, the investor needs to estimate the growth levels which could reasonably be achieved over the intended investment term. This estimate can be based on the economic data available at the time as well as similar historic data over a comparable investment period. For example, a trend of increasing interest rates would normally lead to a decline in house prices and vice versa.

The following calculation methodology should be used in calculating the average annual capital growth rate over the investment period. This is best illustrated through an example:

A residential property is acquired for R1 million and the estimated annual capital growth rates are as per the table below. The intended investment period is 5 years.

The first step in the calculation would be to determine the market value at the end of the intended investment period. This is arrived at as follows:

R1,000,000 x 1.01 = R1,010,000 x 1.05 = R1,060,500 x 1.10 = R1,166,550 x 1.12 = R1,306,536 x 1.15 = R1,502, 516.

This means that after 5 years of variable capital growth, the property would have a market value of R1,502,516. The question now is what the annual average capital growth rate was for the entire 5 year period. This can be determined by using the RATE financial function or a residential property software solution.

Click here to view the Property Reality calculation demo.

The result of the calculation is that an average annual capital growth rate of 8.48% was achieved over the 5 year investment period in this example. This rate can now be used as the annual average capital growth rate when performing a comprehensive calculation of investment return (as per Property Reality's Estimated Capital Growth calculator).

This calculation methodology can also be used to calculate the average annual capital growth achieved from an existing residential property investment. Simply use the current market value, adjust this value by the estimated variable capital growth rates over the remaining intended investment period to arrive at a market value at the end of the investment period and perform the above financial calculation over the sum of the expired investment period and the intended further investment period.

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