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Property Investment Return Calculation Methodologies

There are a number of property investment return calculation methodologies that are used to analyze investment return but the real question is which of these methodologies provide the best indication of the investment return that is achieved from a property investment? The various calculation methodologies do not all serve the same purpose and some of the calculations are more useful than others. It is therefore imperative that property investors understand the benefits and shortcomings of each methodology because this knowledge forms an integral part of interpreting the calculation results correctly.

The following calculation methodologies are commonly used in residential property calculation solutions:

  • Internal Rate of Return (IRR)
  • Net Present Value (NPV)
  • Return on Equity
  • Rental Yield
  • Weighted Average Cost of Capital (WACC)
  • Capital Growth
  • Interest Rates

Internal Rate of Return (IRR)

An accurate calculation of the internal rate of return (IRR) of a property investment is by far the most useful method of calculating the cumulative property investment return, measuring the investment return on an ongoing basis and comparing different property investment opportunities. The IRR is calculated by first determining the annual cash flow that is generated by a residential property investment and then calculating an annual investment return percentage. This percentage is calculated by discounting all the annual cash flow totals to a net present value of nil, thereby resulting in an annual investment return percentage that takes all the cash flow that is generated by the property investment into account.

The calculation of an IRR could be quite tricky and as with many other calculation methodologies, the calculation is only as useful as the data on which it is based. It is therefore imperative that all the property variables that have a significant effect on property investment return are included in the annual cash flow totals that are calculated. The following residential property calculation variables should therefore be included in the calculation:

  • Property financing (bond amount, bond period, interest rate)
  • Transfer & bond costs
  • Rental income & occupancy
  • Operational costs (rates, levies, property management fees, repairs & maintenance, insurance, etc.)
  • Selling costs (agents commission, marketing costs, bond cancellation fees, etc.)
  • Annual capital growth rates (used to determine the appropriate annual market values)
  • Property Income tax
  • Capital gains tax
  • Average inflation rate (for comparing actual investment return to the average inflation rate)

It is also important to note that the IRR indicates what the overall investment return of the property investment is on an annual basis. The percentage that is calculated reflects the annual return on investment that is achieved over the entire investment period. The IRR is therefore the best indicator of overall investment return but is not very useful if you only want to calculate the investment return for a particular annual period.

Return on Equity

The return on equity ratio is calculated by dividing the annual net profit or loss by the equity balance at the end of the particular period. The calculation reflects the investment return for a single annual period and is therefore an extremely useful property investment return indicator that we recommend using in conjunction with the IRR calculation. The IRR indicates the cumulative investment return on an annual basis over the entire investment period and therefore does not provide an indication of the investment return that is achieved in any particular annual period. If the IRR is therefore used in conjunction with the return on equity ratio, the property investor will be able to analyze both annual and overall investment return.

Equity in a residential property context is commonly defined as the difference between the market value of a property and the outstanding bond amount. We don't entirely agree with this definition because we believe that the net realisable value of the property should be used instead of the market value. This means that the costs that will be incurred if the property is sold should be deducted from the market value when determining the appropriate equity balance. The cost of disposal consists of the selling costs like agents commissions and marketing costs, any bond cancellation fees that may be incurred and the capital gains tax amount that has to be paid to SARS if a capital gain is realised on the sale of the property.

The annual net profit or loss of a property investment should be calculated by deducting the interest and operational costs from the rental income that is received from leasing the property. The annual increase or decrease in the value of the property, the movement in the provision for selling costs and capital gains tax and the property income tax should also be taken into account. The annual net profit or loss is therefore quite a complex calculation and an accurate residential property calculation solution may therefore be required in order to calculate this amount accurately.

Net Present Value (NPV)

The net present value (NPV) is commonly used in conjunction with the IRR calculation. The NPV is also calculated from the annual cash flow totals (as is the case with the IRR calculation) but the a user defined discount rate is applied to the annual cash flow totals in order to determine whether the actual investment return exceeds the return that is specified by the discount rate. The result of the NPV calculation is therefore an amount instead of an annual investment return percentage. A positive NPV amount indicates that the investment return exceeds the discount rate that is specified in the calculation and a negative NPV indicates that the return is less than the discount rate that is specified. The amount that is calculated therefore also indicates the amount by which the actual investment return exceeds or falls short of the discount rate.

The NPV calculation can be used to determine whether the actual investment return of a property exceeds the average inflation rate over the investment period by simply including the average inflation rate as the discount rate in the NPV calculation. The NPV can also be used to determine whether the actual investment return exceeds a required investment return by simply including the required return percentage as the discount rate in the NPV calculation.

Rental Yield

The rental yield is calculated by dividing the annual rental income that is received from an investment property by the estimated market value of the property. It is therefore an indication of the income that can be earned from a property investment in relation to the property's value (or in some cases the purchase price) but the rental yield is not an indication of the overall investment return of the property investment.

The rental yield could however be an extremely useful property indicator. Although it only measures the income earning potential of a property against its market value, the calculation is very simple and it can be used in order to compare different investment opportunities. The fact that the rental yield calculation ignores the financing of a property, the potential income tax and capital gains tax liabilities and the cost of disposal of a property does not make it less useful as long as the property investor understands what the purpose and shortcomings of the calculation are.

The property variables that are ignored mainly relate to the structure in which investment properties are acquired and in most investment scenarios, the structure will be the same regardless of the property that is acquired. This means that the rental yield ratio would be calculated on the same basis for all the properties that the property investor is comparing to one another and the calculation would remain accurate. As long as property investors understand that the rental yield is not an indicator of overall investment return, the calculation can therefore be quite useful.

The rental yield calculation that we've referred to up to this point can also be described as the gross rental yield. We recommend using a net rental yield instead because this ratio is calculated by deducting the operational costs from the rental income and then dividing the result by the market value of the property. This means that the operational cost structure (rates, levies, insurance, repairs & maintenance, etc.) is also included in the calculation and therefore provides a property investor with a better indication of the income earning potential of a property after considering operational costs. If the operational cost structures of two similar properties differ substantially and the gross rental yield is used to compare the properties, the investor may decide to invest in the wrong property!

Weighted Average Cost of Capital (WACC)

The weighted average cost of capital (WACC) is calculated based on the amount of debt and the amount of equity that is used to finance the acquisition of a property and the cost of the debt and equity financing components. For example, if a R1 million residential property is financed by a 10% deposit from the property owner's funds and a 90% bond and the cost of equity is 25% and the cost of debt is 10%, the WACC calculation will look like this:

(10% x 25%) + (90% x 10%) = 11.5%

Note: The cost of equity may be subjective depending on the investor who contributes the equity funds. One property investor may be satisfied with a return of 15% per year on an equity investment, while another investor may only be satisfied with a 25% per year return on investment. The bond interest rate should be used as the cost of debt percentage.

Once the WACC has been calculated, it can be used as a required return percentage in order to determine whether an investment provides a return that exceeds the weighted average cost of capital. The NPV calculation methodology is used to perform this calculation but the annual cash flow totals that are included in the calculation usually does not take the interest, property income tax and the increase or decrease in the market value of the property into account.

This is a major shortcoming of the WACC calculation methodology in the residential property market context - the WACC is usually quite an effective measurement for determining the value of a business or capital investment project because the cash flows that are generated by a business or project are usually quite consistent and the assets that are used to generate the cash flow do not represent a significant part of the value of the investment. The increase or decrease in the value of a property does however represent a significant portion of the value of the investment and if the WACC calculation methodology is applied to residential property investments, there is a significant risk that the incorrect investment decision may be arrived at. We therefore believe that the IRR, NPV and return on equity calculations should be used instead.

Capital Growth

This might seem obvious but - capital growth does not equal investment return! Even though the capital growth rate that is associated with a property investment is a significant contributor to investment return, there are a lot of other property variables that also have a significant effect on investment return. Inexperienced property investors and home owners who only look at capital growth as a measure of investment success are always surprised by the difference between the earnings that they expected to realise from a property investment and the actual investment return. Property financing and the nature of home loan amortization plays an important role in this expectation gap, not to mention the effect of property income tax and capital gains tax. A thorough understanding of the property variables that influence investment return would result in no such expectation gap and by using the IRR, NPV and return on equity calculations in order to compile an accurate investment return forecast, the property investor will not be disillusioned by the investment return that is actually achieved.

Interest Rates

Even though the movement in interest rates is an important factor to consider when making property investment decisions, the exercise of simply comparing interest rates to capital growth rates as an indicator of investment return is an entirely incorrect approach. There are a lot of other residential property variables that affect investment return and that are not taken into account in such a simple comparison. 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 that need to be considered are that interest rates already incorporate compensation for the time value of money (the effect of inflation) and in the case of buy to let properties, the interest that is incurred can generally be deducted for income tax purposes (refer to the Income Tax page of our website for more information). It is therefore imperative to include all the property variables that have a significant effect on investment return in investment return calculations.

In summary, we believe that the IRR, NPV, return on equity and (to a lesser extent) the net rental yield investment return calculation methodologies are the most accurate and effective for analyzing property investment return. There is currently only one property investment calculation solution that incorporates all of these calculations - our unique range of residential property templates!

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