Case Study - 10 Year Investment Return

This case study reviews the estimated return on investment derived from an averagely priced South African residential property over the past 10 years. Our intention is to highlight the remarkable returns which could have been achieved from buy to let residential property investments over the past decade and to illustrate the methodology used to measure the investment return achieved.

For this purpose, we provide an Excel example of the calculations performed. You will not be able to enter your own estimates and perform your own calculations, but an unprotected version of the Excel model which is used in the case study is available upon registration as a member of the Excel Skills web site. Click on the Investment Return Case Study link to download the example.

We'll start by providing some background information on the Excel model - the investment return calculation input variables can be found on the Calculation sheet and detailed information on these input variables are provided on the Investment Return Calculation Variables page.

We also recommend that you visit the Effective Interest Rate Calculation, Inflation Rate Calculation, Average Annual Capital Growth, Income Tax and Capital Gains Tax pages for more information on the input estimates used in the calculation of investment return.

Investment Return Calculation Results

The calculation of investment return is detailed on the Results sheet of the Excel example. The first line (row 5) includes the Cumulative Net Cash Flow generated by the property investment. These amounts are calculated on the Calculation sheet (row 31). The cumulative net cash flow represents the cash utilised or generated throughout the investment period.

You will notice that the example property is cash negative until period 10 when the estimated profit on the disposal of the property is taken into account. The negative cash flow balances can be explained by the monthly cash shortfall on the investment resulting mainly from the fact that the monthly bond repayment exceeds the net rental income derived from the property investment.

The Return on Property Purchase Price is simply an indicator of the profit made on the investment in relation to the original purchase price. In this example, the profit made on the investment over a 10 year period exceeds the purchase price significantly.

The Net Present Value (NPV) is the amount of cash generated from the investment after discounting the periodic cash flows by the estimated inflation rate. It therefore displays the amount of profit after inflation has been taken into account. The NPV is the total of the annual cash flows in row 33 of the Calculation sheet.

The Internal Rate of Return (IRR) is the annual investment return derived from the property investment after taking all the annual cash flows into account. It is imperative that all significant variables that affect the investment return calculation are included in this calculation to ensure the accuracy of the calculation. The IRR is based on the annual net cash flow in row 31 of the Calculation sheet. The Excel example includes an IRR calculation before and after inflation.

The Average Annual Capital Growth rate indicates the average percentage that the property has increased in value over the 10 year investment period.

These calculations all indicate that an exceptional return on investment has been achieved over the investment period. As you can see, these investment return measurements provide us with a comprehensive and accurate measurement of the cumulative investment return achieved and are therefore extremely useful in measuring the total investment return achieved from a property investment.

The only problem is that these measurements do not provide an indication of the annual investment return achieved. We are therefore unable to determine whether the investment is still in fact profitable on an annual basis and still justifies the funds which have been tied up in this investment.

We therefore need some sort of annual measurement of investment return which can indicate whether an investment is profitable on an annual basis and calculate the actual annual return on investment achieved.

The calculation of an annual IRR does provide a better indication of the overall investment performance from year to year (refer to row 33 of the Result sheet). The basis for the calculation is quite complicated though - both the cash flow and net realisable value (market value less selling costs less outstanding bond amount) of the investment needs to be taken into account.

From the calculation, we can conclude that the investment is profitable throughout the investment period, but that the IRR (which is always calculated on a cumulative basis) decreases gradually towards the end of the investment period. In theory, the IRR will decrease if the annual return on investment is less than the cumulative IRR at the end of the previous period. This does not necessarily mean that the investment is not still profitable though.

We therefore need a separate measurement of annual return on investment. The Return on Equity calculation enables us to measure the investment return for each year individually. Visit the Return on Equity Calculation page for more detail on the calculation methodology.

From the Excel example calculation results (row 37), we can see that the investment has been exceptionally profitable throughout years 1 to 7, but that the return on investment has declined since then. In fact, for years 9 and 10 a loss has been incurred!

Ratios

The Excel example also includes four financial ratios which are also extremely useful. The first is the Rental Yield which provides an indication of the net rental return as a percentage of the market value of the property. It enables property investors to compare the rental return achieved from various property investment opportunities.

The second ratio compares the outstanding bond amount at the end of each period to the original bond amount. This ratio provides an indication of the amount of capital which has been repaid on the bond. As you can see, more than 75% of the bond is still outstanding after 10 years of repayment! Visit the Home Loan Amortization page for more detail on this subject.

The next ratio is referred to as the Equity 2 on Market Value ratio. As explained on the Return on Equity Calculation page, the Equity 2 amount is calculated by deducting selling costs from the difference between the property market value and the outstanding bond amount. This provides a clearer indication of the equity which can be realized when the property is disposed of. The ratio provides an indication of the equity value which is included in the market value of the property.

The last ratio represents the disposal cost as a percentage of the market value of the property. It therefore provides an indication to the property investor of the costs which will be incurred when the property is disposed of. The disposal costs are calculated as the sum of the selling costs (estate agents commission) and capital gains tax liability.

Summary

From the investment return calculation results in the Excel example, it can be concluded that the past decade has been an exceptional time for investing in residential properties. The main reason for this is the capital growth rates which have been achieved during this period.

The case study was based on the average annual capital growth rates calculated in the ABSA House Price Index (row 11 on the Calculation sheet) and an estimated average negative growth rate forecast for the 2010 year.

You will also note that the investment return achieved during the last two years of the case study were far from exceptional. In fact, the Return on Equity for both these years were negative. Based on current economic conditions, it seems that a case study of the investment return achieved during the next decade could look substantially worse. Property investors should therefore be prudent in making investment decisions and an essential part of this approach is to perform proper calculations of forecasted investment return.

An unprotected version of the Excel model that is used in this case study is available from the Excel Skills web site. This model enables you to enter your own estimates when performing the investment return calculations that are illustrated in this case study. The model is only available after registration as a member of the Excel Skills web site and payment of the annual membership fee, but you will also gain access to more than 260 Excel 2003 tutorials and more than 320 Excel 2007 tutorials covering most of the core functionality that is included in Microsoft Excel. Click here to visit the Excel Skills web site.

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