Property Investment Return Calculation Variables

A calculation of property investment return can only be as accurate as the input variables which are included in the calculation. It is therefore essential for property investors to develop a comprehensive understanding of the nature of all input variables which have a significant impact on investment return.

In this section, we identify the input variables which should be included in a calculation of property investment return and recommend a methodology for estimating and including these variables in the calculation.

Please note: it is of utmost importance to ensure that accurate calculations of investment return are performed because these calculations play an important role in making investment decisions. It is therefore equally important that all major input variables are considered when calculating investment return.

For the purpose of providing guidance on this subject, we have included an Excel example of a property investment return calculation. This example covers a 10 year investment return case study of the SA residential property market and can be downloaded by clicking the link at the top of the page. The example is provided by www.excel-skills.com - you will however not be able to perform your own calculations, but an unprotected version of the example is available upon registration as a member of the Excel Skills web site.

Refer to the Calculation sheet of the Excel example - this discussion will only focus on the residential property variables included on this sheet.

Property Financing

This group of variables relate to the financing of a property acquisition and includes the property purchase price, deposit amount, purchase date, bond period and interest rate. The bond amount is calculated by deducting the deposit amount from the purchase price and is amortized over the bond period at the interest rate specified.

The interest rate is the most important variable in this group because it is used to calculate the monthly bond repayments which have a significant influence on the investment return calculation. When the investment return which will be achieved from a property investment is forecasted, the current prime interest rate (or a discounted rate based on the current prime interest rate) should be entered for this variable.

The prime interest rate is subjected to continuous change based on the fiscal policy determined by the SA Reserve Bank. It could therefore be quite problematic to determine the interest rate which should be used to measure the investment return on existing property investments. One possible solution is to include the applicable periodic prime interest rate in an amortization table to determine total bond repayments and interest over each period of the investment term. This is the approach used in the Excel example - refer to the ActualAmort sheet for the amortization details.

In the example, each month end prime interest rate is looked up in a table containing the applicable interest rates from 31 January 1997 to date. The functionality is also provided to enter interest rate estimates for future periods. Finally, these prime interest rates are adjusted by the discount rate entered on the Calculations sheet.

This approach facilitates reasonably accurate interest rate estimates, but we believe it is prudent to point out that interest calculations per an amortization table could differ slightly from the interest calculated on a bond statement. Refer to the Bond Statement vs Amortization case study for more detail on this subject.

The only method of ensuring 100% accuracy in including interest rates and therefore monthly bond repayments and interest in an investment return calculation is to capture the actual bond repayments individually and calculate the total interest paid during each annual period (for income tax purposes) before including it as part of the investment return calculation. This approach is followed in the Property Reality software solution.

As mentioned above, property financing input variables are used to calculate the bond repayments which are included in the investment return calculation. These variables also determine the interest deduction for income tax purposes (relating to buy to let properties) and the outstanding bond amount at the end of each period during the investment term.

The deposit amount should be included as a cash outflow in the initial period of the investment return calculation (period 0 in the example).

More detail on the interest rate variable and the calculation of an effective interest rate can be found here.

Transfer & Bond Costs

This category of input variables includes transfer duty, conveyance fees, bond registration costs and other miscellaneous registration charges. Transfer duties make up the most significant portion of these costs. These duties are levied at different rates for individuals and corporations.

The current legislation determines that where the property buyer is an individual, there are no transfer duties levied on the first R500,000 of the purchase price, 5% on the amount between R500,000 and R1 million and 8% on amounts over R1 million. The transfer duties applicable to corporations (companies, closed corporations and trusts) are calculated at a fixed rate of 8%.

The transfer and bond costs should be included as a cash outflow in the initial period (period 0) of the investment return calculation.

Operating Income

This category consists of the monthly rental income earned on buy to let properties, the occupancy rate and an annual estimate of the increase in rentals over the period of investment. These variables represent a practical approach to including rental income over the investment period. The initial estimate of monthly rent income is increased by the rent increase percentage for each subsequent period of the investment term.

This approach should result in a reasonably accurate estimate of rental income, but if a 100% accurate calculation of actual investment return is the objective, the actual rental income for each period should be included in the calculation individually. This approach is followed in the Property Reality software solution.

Operating Expenses

This category includes all operational expenses which are incurred on an ongoing basis - these include rates, property management fees, levies, repairs & maintenance and insurance. For the purposes of an investment return calculation, initial cost estimates are made and then increased by a cost inflation percentage for each subsequent period of the investment term. Again, this approach will probably not result in a 100% accurate calculation and the only method of ensuring this accuracy is by recording the actual amounts using a property software solution.

Selling Costs

This category includes mainly the estate agent commission which will be incurred when the property is sold. The calculation approach is to specify a fixed percentage and to apply this percentage to the market value of the property on the deemed date of disposal.

Market Value

The most efficient method to use for calculation purposes when estimating a property's market value is applying an average annual capital growth rate to the initial purchase price. This rate could be calculated based on statistics released by major financial institutions or based on area specific information obtained from estate agents. Refer to the economic data section of our web site for the ABSA House Price Index statistics.

The average annual capital growth rate could be determined for the entire investment period or a growth rate estimate could be entered for each annual period during the investment term. The latter approach is used in the Excel example. Click here for more detail on this variable.

Income Tax and Capital Gains Tax (CGT)

Income tax is payable on the operating profit derived from a property investment, while capital gains tax is payable on the disposal of a property investment for more than the total acquisition cost. These variables are often omitted from investment return calculations resulting in inaccurate calculations which could contribute to incorrect investment decisions being made.

The effect of income tax and CGT is significant and these variables should therefore always be included in a calculation of investment return. Read more about income tax and CGT calculations by clicking on the links.

In the Excel example, income tax and CGT are calculated by applying the applicable tax rate input variable to the calculated taxable income amount before including the result in the investment return calculation.

Inflation

The principle of discounted cash flow is regularly used to compare the investment return derived from a property investment to the average inflation rate over the investment period. In the Excel example, we have calculated the cumulative inflation rate from the rebased CPI index and used this rate to discount the total cash flow for each period to a Net Present Value. The NPV therefore reflects the return on investment after taking inflation into account. Read more on the calculation of the appropriate inflation rate here.

The Excel investment return calculation results are detailed on the 10 year Investment Return case study page. We have also included a separate section on the Return on Equity calculation.

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