| |
|||||
 |
 |
 |
 |
 |
 |
|
|
||||||||||||
|
|
Property Investment Return Calculation MethodologiesThere are a number of investment return calculation and measurement methodologies used by property investors. These calculation methodologies do not all serve the same purpose and some are more useful than others. It is therefore imperative for the investor to understand the methodology which is being used, interpret the results and be aware of any possible shortcomings. The following commonly used methodologies are discussed: Internal Rate of Return (IRR) Net Present Value (NPV) Rental Yield Return on Equity Weighted Average Cost of Capital (WACC) Capital Growth Interest Rates Internal Rate of Return (IRR) An accurate and comprehensive calculation of the internal rate of return (IRR) of an investment is by far the most useful method of calculating property investment return, measuring investment return on an ongoing basis and comparing different property investment opportunities. The IRR is calculated by first determining the total cash flow derived from an investment during regular investment periods (usually years) and then calculating an annual investment return %. This % is calculated by discounting all the annual cash flow totals to a net present value of nil, thereby resulting in an annual investment return % which takes all the cash flow generated from the investment into account. The calculation of an IRR could be quite tricky and as with any other calculation methodology, it is only as useful as the data which is used to calculate it. For most investors, this therefore means that they need a custom designed solution to facilitate the calculation of IRR. The Property Reality software program is the most comprehensive solution of its kind for the South African residential property market and uses the IRR methodology in all its investment return calculations. An accurate IRR investment return calculation should include the cash flows relating to the following residential property calculation variables:
As can be seen from the above list of variables, the IRR provides the investor with the most comprehensive and accurate indication of investment return. We therefore recommend that all property investors should use this means of calculation when comparing property investment opportunities and measuring investment return on an ongoing basis. Net Present Value (NPV) The net present value (NPV) is commonly used in conjunction with the IRR calculation. NPV is also calculated from periodic cash flow totals as with the IRR, but a discount rate is included and a net present value amount is calculated instead of a return percentage. The average inflation rate in effect over the investment period is commonly used as a discount rate to determine whether an investment provides a return in excess of inflation. An investor's required return from a property investment could also be used as a discount rate and the NPV would then measure whether the calculated return exceeds the requirement. A positive NPV amount indicates that the investment return exceeds the discount rate while a negative NPV indicates that the return achieved will be less than required. The amount displayed will therefore also indicate the amount of the excess or shortfall. The NPV is most useful when it is applied in conjunction with the IRR. Rental Yield The rental yield is calculated by dividing the annual rental received from an investment property by its estimated market value. It is therefore an indication of the income which can be derived from a property investment in relation to its price, but does not represent a calculation of investment return. The rental yield is a very useful ratio though. Although it only measures income against market value, the calculation is very simple and it can therefore be used effectively to compare different property investment opportunities. The fact that it does not take financing, income tax, capital gains tax, selling costs and inflation into account does not make it less useful as long as the investor understands what the main purpose of this ratio is. These variables also tend to relate to the investor's personal financial position and the structure in which investment properties are acquired, factors which would not generally differ between investment opportunities. There is however significant risk in ignoring the operational cost structure of a property investment. One property could incur significantly higher rates or levies and need a lot more repairs on an ongoing basis which is not taken into account when basing calculations on the rental income alone. This risk can be reduced by calculating a net rental yield instead of a gross rental yield - the net rental yield is calculated by subtracting operational cost from rental income and dividing the result by the market value of the property. In summary, even though the net rental yield provides the investor with a handy ratio for comparing property investment opportunities it does not negate the need to perform comprehensive investment return calculations using the IRR and NPV calculation methodologies. Return on Equity This ratio is calculated by dividing the return derived from an investment by the owners' equity contributed in order to generate this return. This ratio is commonly used in analyzing businesses and provides a very useful indication of the return on investment. In terms of the calculation, it could be problematic to calculate this ratio for individual residential property investments. By definition, this ratio is calculated by dividing the net profit after interest and taxes by the equity contributed for each year in the investment period. Residential property investments are not the same as investing equity in a business where an annual return on investment is generated from the equity originally contributed. The main aim with residential property investments is to generate an increased capital value of the asset which is invested in which does not reflect on an annual basis. An annual loss (shortfall) could also commonly result from the investment, even though the capital value might have increased. The application of this ratio to residential property investments could therefore be quite complicated and even if the increased capital value is added to the operating results at the end of each year, the calculation result could not be that useful. The IRR and NPV calculation methods are therefore simpler and more useful investment return calculation techniques. Weighted Average Cost of Capital (WACC) The weighted average cost of capital (WACC) is calculated based on the relationship between equity and debt in the financing structure of an investment and the cost associated with each of these components. Therefore, if a R1 million residential property is financed by a 10% deposit from owner's funds and a 90% bond and the cost of equity is 25% and the cost of debt is 14%, the WACC calculation will look like this: (10% x 25%) + (90% x 14%) = 15.1% Please note: the cost of equity is subjective; one investor may be satisfied with a return of 15% per annum on an investment while another investor will be satisfied only with 25% per annum. The bond interest rate should be used as the cost of debt percentage. Once a WACC has been calculated, it can be used as a required return % to determine whether an investment provides a return which meets this requirement. The IRR and NPV calculations are used to calculate the result and the WACC can therefore be effectively used in conjunction with these methodologies. The debt / equity ratio needs to be recalculated on an ongoing basis. It is common for buy to let properties to result in a cash flow shortfall which is required to be funded by contributing more owners' capital (equity), while bond repayments will reduce the debt balance. Capital Growth This might seem obvious but - capital growth does not equal investment return! Even though the capital growth rate associated with a property investment is a significant contributor to investment return, there are a lot of other variables which also need to be taken into account. Inexperienced investors and home owners who only look at capital growth as a measure of investment success are always surprised by the difference in expectation between what they thought they would earn from a property investment and what eventually ends up in their pockets. Property financing and the nature of amortization plays an important role in this expectation gap, not to mention the effect of capital gains tax. A thorough understanding of the variables which influence investment return would result in no such expectation gap and the use the IRR and NPV calculation methods will enhance this understanding. Interest Rates Even though interest rates are an important factor to consider for property investors, simply comparing interest rates against capital growth rates is an incorrect approach. There are a lot of other factors to consider when forming expectations around investment return. It is entirely possible that an acceptable investment return could be achieved even though the capital growth rate is below the interest rate. Important factors to consider is that interest rates by nature already incorporate compensation for the time value of money (the effect of inflation) and in the case of buy to let properties, the interest incurred can generally be deducted from income tax (read the Income Tax section for more information). It is therefore imperative to perform calculations which incorporate all significant variables - as is the case with the IRR and NPV methodologies. |
 |
|
