Total real estate returns is made up of a combination of income and capital gains. In order to maximise long term real estate return is by knowing the key drivers in each component which will create value.
A common trap for new investors in property is evaluating investments just based on the income yield on a property. A high income yield could mask a value trap as much as an opportunity of lifetime but it is important to understand why the property is trading where it is.
In most instances the high yield is unsustainable or it is to compensate for the risks reflecting the area or type of property where there is limited chance of improving the income hence capital appreciation down the road.
You can outline the risks from an investment but you can’t put risk into a property return calculator, rather you have to use your own judgement. We previously highlighted risks investing in residential and commercial real estate so the focus here mainly will be on the breakdown of the return portion of the investment.
Real Estate Rental Returns
Rental income makes up the bulk of the income from investing in real estate. In some circumstances there’s ancillary income the tenant will pay such as parking or storage as well as contribution towards utility.
In some cases in commercial real estate the tenant incentive can be rentalised and inflate the passing income by giving the tenant a high incentive and claw it back via a higher rent.
Real estate is primarily known as a secured income product because of its rental return component which makes up the monthly and annual cash flow of the asset. The asset cash flow can be considered to be highly certain since there is a lease contract which stipulate the term of the lease, amount of rent and rate of increase overtime.
During the period when the property is not occupied or during lease negotiation with new tenant while the income is uncertain. An independent valuation of the property will put a market rent against that space so the value of the property reflect the expected future downtime.
Real estate asset class is known for its dependable cash flow because any variation to the lease will be a breach of contract and income is only at risk if the underlying tenant credit is poor. This is why it is crucial in vetting and qualifying tenants during the lease up period and where in some instance a discount to market rent is justified for government tenants which is able to sign extremely long leases or top tier companies which is less likely to default. In the latter case, the company share price can be used as an early warning indication of distress.
Gross rent is the headline revenue line of the property income. Operating expenses should also be taken into consideration in calculating the net rental return. Operating expenses include payments for the property managers to look after the property, costs of operating a building, valuation, strata fees if the property is an apartment, utility and water if they are not covered by the tenant as well as taxes and rates. Also in most states land tax on real estate owned by foreigners would be at a higher rate.
Gross Rent – Operating Expenses = Net Rental Return
Over time the income from the property would make up a large portion of the investment return. This is why during purchase or analysis of potential property investments that the focus should not only on what the rent is today but also the potential for the market rent for the area to increase overtime.
If the asset is located in a good area and that no new supply is expected then it is highly likely that market rent will increase overtime as there is always demand for property in good areas. However if you are buying in a saturated market with room for more supply to come onto the market then it is very unlikely that rental growth will be strong. A strong rental growth profile is important as it will increase income received and value of the asset (see further below).
For simplicity on a cash basis, capital expenditures items are reduced from net rental income in the cashflow as these are largely discretionary and while ongoing, are one time items. From an accounting perspective the cost of capital expenditure is the annual depreciation amount.
The Net Rental Return is an asset level metric. The true net income figure need to account for the interest cost on the debt used to finance the purchase and it is obvious that the above assume positive gearing in which the total income is higher than the cost of debt.
Real Estate Capital Gains
The difference between the sale price of an asset and the purchase price is called capital gain. Property capital gain can be calculated using the net purchase price which is the price paid including the stamp duty and legal costs.
Legal costs are usually forgotten piece in cost budgeting during the purchase. For residential houses this include conveyancing and solicitor costs. Legal costs in commercial real estate include drawing up the contract which is called a sale and purchase agreement, and due diligence which is legal review of all material documents from a legal perspective.
There are also brokerage costs when it comes to selling the investment property which are typically 1 to 2% depending on the market and some legal costs.
The price after all the cost above and the original net purchase price make up the capital gain.
How Does Capital Gains Happen?
Real estate capital gains are not certain and the ultimate appreciation is only known when the asset is sold often years after the initial purchase. It is very hard to forecast capital gains into the initial purchase analysis since no one can really forecast what the market can do years down the track.
There are some science in the yield in calculate changes in asset value in which capital gain or loss can be derived. Cap rate valuation is the simplest form of valuation analysis and the process is simply dividing the net income by the cap rate.
For example if an asset is purchased with $1 million of net income at 5% cap rate. The value is $20 million by cap rate assuming no capital expenditure and the passing income is equivalent to market rent.
If over 5 years the income increased to $1.1 million and if there is transaction evidence that a similar asset will trade at 4% cap rate. Then the value of the asset is now $27.5 million. There is a $7.5 million capital gain on the asset and a net capital gain slightly lower after taking into account the stamp duty and transaction costs paid at purchase.
This is one way that capital gain can be measured without selling the asset. Depending on the valuation method adopted either cap rate, direct comparison or rate per sqm. There are numerous ways to calculate the expected capital gain on real estate.
The independent valuation sets the value of the asset to determine the unrealized capital gain return until the sale occurs which is when the capital gain is realized. We are always skeptical of valuation numbers and will not going in detail on how valuation can be gamed even if it is conducted by an independent party. They should always be used as a guide with the only number important to us being the sale price. Any interim valuation is used as a guide since the valuer is not actually buying it at that price.
In most instances it is hard to come up with a reasonable exit price at the start outside of using general assumptions based on current market evidence. Without supporting evidence, on a fundamental level betting on aggressive capital gains return is to a degree reliant on the greater fool theory and in worst case leading to market bubble.
How Investors Calculate Real Estate Returns
There are a number of ways to calculate real estate returns. Each investor has a different metric depending on risk profile, the importance of income or income capital mix agnostic and they just have an absolute return focus.
Cash on Cash Return on Real Estate – A Return on Cash
One of the most basic real estate return measure is cash on cash return. Cash on Cash return is a return metric which calculate returns using the cash return of income and capital gain based on the equity cash contributed to the investment.
This means is that in the real estate return calculation, the cash return of the property is the net rental income after all expenses and capex. The capital gain is only measured at the end in the event the asset is sold rather than annually.
As an third party independent valuer can opine on the value the asset during the hold period any change in value is not accounted for in the return calculation until the asset is sold.
This combined with the cash income received over the last 12 month forms the total investment property cash on cash return for the year.
As the name suggest cash on cash return only counts the cash coming in and out.
We have not gone into detail what makes it a good real estate investment, indicators or methods in getting the highest return from property but before going into depth it is important to understand the metrics that the incoming cash will be benchmarked against. Otherwise you’re just flying blind.
Yield Return Metrics
For some real estate investors such as a large portion of Australian real estate investment trusts the ingoing yield of the investment will be the key return metric. This yield commonly referred to as the passing yield or cap rate if the market rent is adopted is an important return metric as REITs income driven vehicles.
The different types of yields include:
- Initial Yield – the yield at time of acquisition
- Market or Cap rate yield – which is the yield on the asset if the market rent is adopted instead of the passing rent. This is important as sometimes the asset can be over or under rented so a cap rate is a more reflective the like for like yield.
Being an listed entity which regularly paying distribution means that it is paramount to maintain that the dividend income stream going forward. Any purchase they make must either be accretive or with minimal dilution.
The focus on yield metrics only in real estate return can be dangerous as the quality of the investment is secondary to the headline yield.
Internal Rate of Return and Equity Multiple
Internal rate of return or IRR is a simple calculation of investment return which take into account the time value of money. It is the most common form of evaluating real estate return by institutional investors or real estate private equity groups.
IRR is simply the discounted cash flow approach to real estate investment and a simple representation of the return in investing in the opportunity. Investors also like using IRR because it allows returns between projects to be compared easily. For example for the same level of risk the return from 2 projects are 8% and 10% then the choice is pretty straight forward.
The main short fall of the IRR metric is it does not account for absolute dollars invested. Therefore most people uses equity multiple in conjunction with the IRR metric. Equity multiple is calculated by the total dollar return by the total dollar invested. e.g 1.5x EM means that every dollar invested result in $1.5 by the end of the investment term.