evaluating an investment property

overview

Property can hold different meaning to different people. For some it is merely a form of shelter where they lay their head at night. The locale and size may not even be of concern, simply that there is a certain basic level of comfort. For others, property can be a status symbol, where one’s postcode and square meter coverage may be advertised as a sign of their so called success. Property can also be something in which fortunes are made through the accumulation of a portfolio of investment properties.

Rather than provide comment on the first two which are arguably highly subjective, it is in the third that a degree of objectivity is possible.

Contained below is a property evaluation model that aims, given certain assumptions, to provide the user with a valuation tool to aid in the assessment of the profitability and appropriateness of an investment property.

The choice of whether to purchase a property to be a primary place of residence for a single occupant through to that of a family is a very different topic and the quantifiable financial metrics are arguably not as important as they would otherwise be for a property that is to be purchased strictly for investment purposes.

The aim of this model is to aid in the decision making process of purchasing an investment property. The model uses IRR, NPV and time weighted nominal cash flow analysis to examine the metrics surrounding the potential investment. It should be viewed as a tool that provides insight into the merits of the investment, as opposed to providing an unambiguous recommendation. As with any investment, it is up to the investor to use whatever tools they may have at their disposal to evaluate the potential venture, with the final judgement being their own.

One important aspect of the model is the concept of opportunity cost. Often when property is evaluated for investment purposes, the opportunity cost of using those funds elsewhere is not taken into account. This is especially true for those properties that are negatively geared. To elaborate, regardless of any potential tax benefits, negative gearing by definition means that one is relying on an eventual capital gain to justify the continued need to provide additional cash injection into the asset over the period in which it is held. Should the capital gain realised more than offset the additional cash injections, than most would argue that this has been a successful investment. However, this ignores opportunity cost. A preferred manner in which to evaluate the merits of the investment property is to compare investing those cash flows through time in an alternate asset (be equity, bonds, cash, commodities whatever) and examining what the difference in the terminal values are. Arguably, an important consideration in determining the merits of a property investment is does the property's projected net profit after tax provide sufficient return over and above an alternate investment that may require much less regular maintenance or ongoing hassle as it were.

What the model captures is not only the after tax net profit from the property itself but also compares on a like-for-like time weighted basis, the net position for the investor were they to instead direct all the cash flows (including the initial contribution used to acquire the property in the first place) towards the alternate investment instead.

It is left to the end user to make a determination as to the suitability of the property based upon the supplied results. However, in any analysis we would encourage the user to examine the relative performance of the property versus the risk-free cash rate. Although using alternate investments such as bonds or equities should be examined, what the risk-free rate provides is an excellent benchmark against which the property's profitability may be compared to that of simply placing those investable funds in a risk-free zero ongoing maintenance environment - thus providing a nominal dollar value of the inherent compensation being given to the investor for bearing the associated risks of the property. The acceptability of this will depend on the risk preferences of each investor, but can often provide surprising results – that is to say, depending on certain assumptions, one may find that they are not being compensated to the extent they might have expected. In the most extreme cases, it may indeed be that unless significant price gains are made on the property, that the risk-free option provides a greater return!

the model

The model can be downloaded by clicking here.

An instruction manual is provided here to assist with the model's use.

The model is Excel based and requires the use of macros. Please ensure that the ability to run macros is enabled within the security settings.

A publication produced by the ATO dealing with the tax treatment of investment properties is offered here for interest. This is the latest version at the time of writing. The model accounts for all the necessary tax implications, but it is a worthwhile read for prospective property investors in gaining an understanding of how investment properties are treated under current Australian tax legislation.

other considerations

One aspect of property investment that the model makes clear is how sensitive the projected results are with respect to the assumed annual house price growth. Indeed, mortgage rates can increase significantly over the life of the investment, but if the house price growth is sufficiently high, then this will more than offset the higher funding costs. On the other hand, even if mortgage rates are historically low, if the house price growth proves to be too little, than the investment will be shown to have been an inferior one – both in absolute and relative terms, and irrespective of whether it was positively or negatively geared.

Therefore, whilst the prudent investor will always aim to minimise their debt funding costs, the most influential factor contributing to the success of the property investment (both in absolute and relative terms) is that of price appreciation. This point needs to be stressed as it behoves any potential investor in property to have a clear understanding of just how much this one factor dominates all others. This may seem obvious and known to experienced investors, but what the model helps to illustrate is just how much price appreciation matters and indeed, under various assumptions, whether investment in the property is worthwhile relative to that of an alternate asset.

It should be noted too that a favourable characteristic of property investment is that of leverage. Unlike other asset classes, for instance equity where leverage is also possible through the use of a margin loan, the loan-to-value ratios permissible on property tend to be much higher without the risk of receiving a margin call. For those investors expecting strong price growth in the value of the property, the model quantifies what the potential gain to wealth would be. Indeed, a useful feature of the model is in demonstrating how property investment may lead to significant wealth accumulation owing to strong price appreciation on the back of generous leverage conditions. But importantly, this goes both ways. The model also demonstrates that, given the extent to which significant leverage (debt) can be present, should price appreciation be somewhat muted, then the relatively large debt servicing costs will result in an investment that provides little gain to one's wealth.

Key theme: Performance of the asset itself, regardless of asset class, will always be the crucial factor in generating wealth from the investment in said asset. Low funding costs or associated tax advantages will not offset a poor performing asset, both in absolute or relative terms.

Given the technical issues inherent with the calculation of the internal rate of return, one should not base their decision on the headline rate alone. Indeed, in DCF analysis it is noted that if there is a conflict between the NPV and IRR, use NPV as the decision tool. Accordingly, the results for the IRR model are presented in such a way as to indicate only whether the property investment provides a positive or negative return (from that model's perspective) – this discourages a focus on the headline rate alone.

Three different approaches are provided in the evaluation to provide reassurance. If all three methods show encouraging and consistent results, the investor can be confident in the eventual realisation of the given result (assuming the assumptions hold of course). However, in deciding whether or not to go ahead with the property investment, an investor should arguably focus most on the model's dollar figure provided which indicates the gain over the alternate investment. At the end of the day, as an investor, profit is the driving motive. But in actuality it is not the rate of return per se, but the actual nominal cash value at termination that matters. In other words, an investor may estimate a potential to earn a profit of 20% p.a., however, if this represents a nominal cash profit of only $10,000 p.a. then that investment alone will not lead to financial independence. In light of this, we recommend the use all three methods for assessment, but that ultimately the decision rests upon the nominal terminal gain.

As property is a physical asset that has ongoing associated costs (both in terms of time and money) that OTC or exchange traded products do not have, it is wise to incorporate this into ones decision making process. For instance, if the property was shown to provide a gain of $50,000 after twelve years relative to that of simply placing those funds into a bank account at the risk-free rate – one needs to consider whether $50,000 after twelve years sufficiently compensates for the potential issues with tenants and the associated time costs involved in maintaining the property. An agent may be able to manage these thereby placing less burden on the investor, but this will come at a price, and thereby reduce the comparative gain.

Property investment can be a contentious topic for discussion with many a heated argument emanating from the various opinions. Without wanting to bias the discussion but with an interest to assist and inform, we offer this evaluation tool as a means of providing a degree of objectivity on the subject, and to provide a little clarification in the otherwise complicated decision making process that is property investment.

Please contact info@financialactuality.com to discuss further or enquire about model specificity. We are also able to build other cross asset investment evaluation tools should that be required.