In recent posts to this blog, we’ve looked at relatively simple methods for measuring the return on invested funds.
· The cash-on-cash method measures the rate of return, expressed as a percentage, on invested equity only.
· The capitalization rate, or cap rate, measures the rate of return on all capital invested, debt and equity. It also is expressed as a percentage.
While these methods are commonly used in the industry, they leave much to be desired. Primarily, they measure return for a single annual period, whereas most real estate investments or projects experience a multiyear cycle of development and operation. If your capital is at risk for a period of several years, shouldn’t your measure of return reflect this? Can you really understand and measure return on your investment by looking at a single year’s activity, such as the first year at stabilization?
Another issue is the time value of money. Is a dollar received in Year Ten’s cash flow worth as much as a dollar received in Year One’s cash flow? If you invested $100,000 today and received $200,000 within the first year, did you double your money? What if it took five years to get the $200,000? If you fail to see the difference, ask yourself this question: suppose you won $10,000,000 in your state’s lottery, but the state asked you if it could keep the funds for a couple of years then pay you – no interest accrues. Would you say, “Sure!”? Of course you wouldn’t. It’s the “bird in hand theory”. A dollar received today is worth more than a dollar received somewhere down the road, because, among other things, dollars lose purchasing power over time, inflation eats away at it’s value, there is the cost of lost opportunities, and there is the risk of default or nonperformance. This is the essence of the time value of money.
So, the question is: Given the effects of the time value of money, is there a way to measure return on investment over a multiyear period? The answer is yes, using discounted cash flow analysis. It is a means to measure or assess the present value of cash flows to be generated by the property (investment) in future periods (c.f., years of ownership).
There are three principal discounted cash flow methods utilized in real estate:
· Mortgage Amortization: In real estate, this essentially is a sinking fund in which regularly scheduled payments containing principal and interest are made over a specified period of years so that the final payment completely satisfies the mortgage debt.
· Net Present Value (NPV) : Measures and compares the attractiveness of alternative investment opportunities. This actual defies conventional wisdom by proving that you really can compare apples to oranges.
· Internal Rate of Return (IRR): Calculates the return earned on the invested capital over the life of the investment, not just the initial year.
In this discussion, we’ll concentrate on NPV and IRR.
The components of NPV and IRR calculations are the following cash flows, positive and negative:
· The initial capital invested (negative)
· Subsequent capital investments (negative)
· In-place (existing rents - positive)
· Forecasted (predicted future rent increases - positive)*
· Terminal or reversion (net sale proceeds - positive)*
*These latter two are highly speculative. Since the recent financial meltdown, investors and lenders are more conservative in underwriting the forecasted and terminal cash flows. Thus, in-place cash flows are a larger portion of the calculation – meaning cap rates have to rise, which pushes purchase prices (values) down if the investments are going to pencil out.
The next posting to this blog will discuss Net Present Value specifically.
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