What is the time-weighted return on your property investment?

time-weighted return

The time-weighted return and other time-weighted measures of investment performance and profitability are extremely useful tools for correctly estimating the potential performance of a property investment. Although there may be some isolated exceptions, any evaluation processes of property acquisitions that do not estimate time-weighted measures of expected investment performance can hardly represent the application of smart real estate investing practices.

The return of a real estate investment depends critically on the particular cash-flow stream expected to be received from the property over its holding period. Two are the critical characteristics of the expected real estate cash flows, in terms of measuring its time-weighted performance:

  1. The level of the cash flows in each period
  2. Their timing

Ignoring the timing of cash flows when calculating the profitability of a real estate investment, may lead to misleading assessments of its profitability and unwise investment decisions. That is why it is very important to estimate the expected time-weighted return of a potential property investment before making any acquisition decisions.

Time-weighted measures of real estate investment performance are not perfect, and by no means can perfectly predict the actual return that will be realized over the holding period and when the property is eventually liquidated by the investor because simply they are calculated using predictions of the property’s future cash flows. Since predictions can never be perfectly accurate, especially the medium-term and long-term ones, the time-weighted measures of property investment returns that are based on such predictions cannot be perfectly accurate as well. For this reason, smart property investors will view these estimates of future performance with caution and try to also assess the level of uncertainty and risk associated with the realization of the predicted cash flow streams.

The major time-weighted measures of real estate investment performance are the following three:

  1. Present Value
  2. Net Present Value
  3. Internal Rate of Return

Present Value (PV)

The Present Value (PV) technique estimates the value of the expected cash flows of the property over the anticipated holding period to an investor, taking into account his/her required rate of return per period. This required rate of return is actually used as the discount rate by which the future cash flows of each period are discounted to the present, in order to estimate their present value.  Since the discount rate is applied to the particular timing of the expected cash flows of the property, it actually represents the expected time-weighted return that will be achieved by the property, if it is acquired at the estimated present value.

The present value technique is used also by valuers when they are asked to estimate the “investment value” of a property. In this case, the valuer will need to survey the particular marketplace in which the property is traded, in order to determine the “market discount rate”, that is, the return that a typical investor in that marketplace would require at the time of valuation for investing in a property similar to the property under consideration.

The present value of a cash flow stream can be estimated in Excel by using the PV function, once the expected net cash flows (revenues minus expenses) for each period have been calculated. Note that in the estimation of present value, the acquisition cost of the property should not be taken into account, since we are actually trying to estimate the value of the property, given its expected cash-flow stream and the return required by real estate investors that are active in the marketplace in which the property is traded. Also note that the cash flow of the last period of the investment horizon needs to include and the expected revenue from the sale of the property (minus any sales costs, such as real estate agent commissions).

Net Present Value (NPV)

The Net Present Value (NPV) technique calculates the difference between the present value of the expected cash flows and the cost of acquiring the property. This cost should include not only the purchase price but also all other costs paid by the investor for acquiring the property including transfer fees and pre-acquisition costs, such as legal, and other consulting fees paid for all the due-diligence required for evaluating a property before acquiring it.

NPV = PV of future cash flows – Investment Cost

If NPV is positive it means that the present value of cash flows is greater than the investment cost, and therefore, the investment is expected to deliver a return higher than the discount rate used for the estimation of the present value of future cash flows. Since, the discount rate used typically represents the required time-weighted return by real estate investors in the particular marketplace, then a positive NPV would also mean that the time-weighted return that the property is expected to deliver, if bought at the acquisition price used in the analysis, will be higher than the return required by investors for acquiring the particular property. The opposite is true if NPV is negative.

It is important to remember that the sign (negative or positive) of the NPV is directly linked to the magnitude of the discount rate used. A negative NPV is not necessarily an indication of a non-profitable or a bad investment. For example, if a very high discount rate has been used, a relatively small negative NPV would not mean too much, because the return of the investment could be still attractive. The ultimate measure of property investment profitability is the third time-weighted measure discussed in this article, that is, the internal rate of return (IRR).

If a loan will be used for financing part of the purchase price, then this needs to be taken into account in the NPV analysis of the property’s cash flows. In particular, the cash flow in the last period of the investment horizon needs to also take into account the repayment of the remaining loan balance. Furthermore, the periodic mortgage payments will also need to be taken into account during the holding period. Finally, only the portion of the purchase price that is financed by the investor’s own funds should be included in the acquisition cost, which is entered at time zero of the cash flow analysis (while post-acquisition property revenues and expenses start from period one).

Time-Weighted Return: Internal Rate of Return (IRR)

The Internal Rate of Return (IRR) represents the expected time-weighted return of the investment, given the expected undiscounted periodic net cash flows (revenues minus expenses) of the property and its acquisition costs. In actuality, the IRR technique calculates the discount rate that renders the present value of expected property cash flows equal to the property acquisition cost, or the Net Present Value of all cash flows equal to zero. Although, the IRR is the most accurate time-weighted indicator of the expected profitability of a property investment, there are some issues that smart property investors should have in mind when reviewing IRR estimates. We elaborate on these issues in our post on how the IRR is calculated.

References

Clauretie, T. M., & Sirmans, G.S.  (2009). Real Estate Finance: Theory and Practice 6th Edition.  Onsource Learning.

Kolbe, P. T., & Greer, G. E. (Author), Gaylon E. Greer.  (2012). Investment Analysis for Real Estate Decisions, 8th  Edition. Dearborn Real Estate Education.

Geltner, M., Miller, N. G., Clayton, J., & Eichholtz, P.  (2013). Commercial Real Estate Analysis and Investments (with CD-ROM). Onsource Learning

Sivitanides, P.  2008. Real Estate Investing for Double-Digit Returns. BookSurge Publishing.

Related Posts

Property Investment Analysis: The Discounted Cash Flow Model
Property Investment Basics: Equity Capitalization Rate
How to Estimate Future Property Value
Property Investment Basics: Before-Tax Cash Flow

 

Author: Petros Sivitanides, Ph.D.

Dr. Sivitanides is a seasoned expert in real estate investment strategy and analysis, property portfolio modeling and strategic analysis, and real estate market research and econometric forecasting with over 16 years of experience with leading global real estate investment managers and real estate consultants (CBRE Global Investors, AXA Real Estate, Torto Wheaton Research, DTZ, etc.). He is the editor of the textbook titled “Market Analysis for Real Estate”, which has been used as the main textbook for a graduate course at Harvard University. He is also the author of the book "Real Estate Investing for Double-Digit Returns" and many widely quoted articles that have been published in popular real estate journals. Currently, he is the Head of the Real Estate Department at Neapolis University in Cyprus, and an international real estate consultant.

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