The payback period is one of several real estate investment performance indicators and represents the number of years required to recoup the initial cash invested in a particular property. More specifically, the payback period is calculated as the number of years over which the after-tax cash flows expected to be received from the property investment will sum up to an amount equal to the initial investment cost paid by the investor. The higher the net operating income (NOI) earned by the property and the faster its growth rate over the holding period, the shorter the payback period of the investment. Usually, the payback period of real estate development projects and property investments is several years.
Simplistic Formula for Payback Period of Property Investment
The simplistic formula below can provide an estimate of the payback period if the anticipated cash flow from the property is expected to be constant through time.
Payback Period = Equity Investment Cost / Annual After-Tax Cash Flow
This simplistic formula has several limitations because annual cash flows of a property are seldom constant, especially in the case of large rental properties with multiple tenants. In order to apply this formula, one needs to calculate the After-Tax Cash Flow (ATCF). The formula for calculating ATCF is the following, assuming that borrowing is used:
ATCF = NOI – (Taxable Income * Tax Rate) – Debt Service
Taxable Income in the formula above is calculated as:
Taxable Income = NOI – Depreciation – Interest Payment
Depreciation methods and rates differ by country and are applied to the purchase price in order to calculate the depreciation amount that will be deducted from NOI in order to calculate taxable income.
How to Calculate the Payback Period
When the anticipated cash flows of the property are not constant, then the payback period for a property investment can be calculated as follows:
- Estimate the total investment cost of acquiring the property. This includes not only the purchase price but also all pre-acquisition costs, including legal, consulting, mortgage broker fees, mortgage product fees, title search, valuation fees and any other costs incurred by the investor towards the completion of the transaction.
- Estimate the anticipated year-by-year after-tax cash flows of the property for the next 10 years taking into account all cash inflows (rental income and other income) and outflows such as land rent, operating expenses, mortgage payment, vacancy loss, tax payments, etc., associated with the ownership and operation of the particular property. These cash flows will most likely differ from year to year.
- Sum up the year-by-year cash flows until their sum equals or exceeds the initial investment cost. In other words, calculate for each year going forward the cumulative cash flow. For example, the cumulative after-tax cash flow in the fifth year will be the sum of the annual after-tax cash flows in the first five years.
- If by the 10th year the cumulative cash flow is still lower than the initial investment cost, the analysis of anticipated cash flows needs to be extended further into the future in order to calculate the payback period. However, bear in mind that the further away in the future your predictions of after-tax cash flows are extended, the less reliable and less meaningful they are.
- The nth year during which the cumulative cash flow equals or exceeds the initial investment cost represents the payback period
Limitations of Payback Period Estimates
The payback period is a useful summary indicator of how fast the investor can expect to receive back the capital invested in a property, especially when the cash flow projections are based on conservative assumptions. However, when examining a payback period estimate for a property investment, it is important to understand its weaknesses and limitations:
- The longer the payback period, the less accurate is the estimate, as the accuracy and reliability of property cash flow projections decline exponentially as we move further into the future. Unless the property you are evaluating involves long-term leases with strong tenants, any predictions of future cash flows beyond the 3-5 year horizon should be viewed with extreme caution.
- The second drawback of using this measure is that it does not take into account the timing of cash flows. If the same cash flows received within the years of the payback period are re-arranged in terms of their timing, we will still get the same estimate for the payback period of the investment. However, from an investment return perspective, the early cash flows weight much more in the overall return of the investment, because they can be reinvested. Thus, investments with the same payback period may have a significantly different internal rate of return (IRR), if the timing of the larger positive cash flows is significantly different.
- The payback period measure ignores completely the cash flows expected to be received beyond the payback period, which is another factor that makes it an incomplete measure of real estate investment performance.
- The described methodology of estimating the payback period does not take into account any additional income received from reinvesting the positive cash flows when they are received by the investor.
In sum, the payback period is a useful indicator of property investment performance, but an incomplete one. It has to be complemented with estimates of the internal rate of return through a thorough analysis of all anticipated cash flows of the property over the investment horizon, using the discounted cash flow (DCF) model.
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). Oncource Learning
Internal Rate of Return (IRR) and Property Investment
Property Investment Basics: Real Estate Return Measures
Property Investment Basics: Operating Statement
Property Investment Basics: Equity Capitalization Rate
Net Operating Income (NOI)
Property Investment Basics: Before-Tax Cash Flow