by Michael Brett
Calculating the real return
We have looked at how discounted cash flow (DCF) sums can be used to calculate the present value of a property to a purchaser under given assumptions and projections: the net present value calculation. This time we are going to do the sum the other way round to calculate the internal rate of return (IRR) from a property.
The internal rate of return is probably the best measure of the total return which an investor gets on his money. The calculation does make certain assumptions — if receipts from the investment are reinvested, they can be reinvested only at the IRR itself — but we do not need to bother too much with the technicalities to grasp the principle.
First, why is an IRR calculation necessary? At the simplest level it is needed because you cannot very easily calculate the return from a property on a rule-of-thumb basis. If you have a property yielding 6%, whose rental value and capital value grow by an average annual compound rate of 10% over the next five years, there might be a temptation to assume that your total annual return would be 16%: the 6% of income plus the 10% of capital growth.
In reality, the return would not be as high as this, because you must allow for the fact that none of the increase in rental value is reflected in the rent payments that you receive until the rent is reviewed at the end of the fifth year. Remember that £1 in the future is worth less than £1 today.
Then, too, the picture may be complicated by additional expenditure on the building during the period you are measuring. And, indeed, you may want to calculate the effect on your returns of spending additional money on improving your investment. Take the following set of circumstances.
An investor owns an office block currently valued at £1m and let at an up-to-date market rent of £60,000 a year (a 6% yield). By the time of the review at the end of year five he expects the rental value to have risen to £90,000.
But suppose he reckons that at the end of year three he will have the funds to improve the building by spending £150,000 on, say, installing an up-to-the-minute lift. If he does this he expects that the rental value of the improved building at the review at the end of year 5 will be £100,000 rather than £90,000. He also hopes that the uprated building might in future be valued on a 5.5% yield (about 18.2 yp) rather than the original 6% (16.7 yp).
Will he improve his rate of return by spending the extra money?
First we need to calculate the rate of return on the building as it stands, given the owner’s assumptions. This involves discounting back all outgoings and receipts for the appropriate periods, as explained in the net present value calculation. The discount rate at which the discounted value of all receipts equals the discounted value of all outgoings (including the original purchase price) gives the internal rate of return on the investment. In other words, the internal rate of return is the rate at which the calculation gives a nil net present value.
The only way of hitting on this discount rate is by trial and error, though fortunately we can get a computer or one of the more sophisticated calculators to go through the process for us. The answer, as it happens, is around 13.6% — this is close enough for our purposes. For simplicity we have again ignored purchase and sale costs, which in practice would be a significant consideration. The calculation is shown in Table 1.
Now we can do the same sum on the assumption of £150,000 expenditure at the end of year three, a rent of £100,000 after the review and an end valuation of £1.82m based on a 5.5% yield or about 18.2 yp. The discount rate at which discounted outlays and receipts now roughly equal each other is, we discover by trial and error, 15.17% (see Table 2).
So what this sum throws up is the fact that the expenditure of £150,000 at year three will be well worthwhile if the property owner’s assumptions turn out to be correct. His return on the total capital invested in the property stands to rise from about 13.6% to almost 15.2% over the five-year period.
This is the sort of sum that a reasonably sophisticated property owner is undertaking when he attempts to decide whether a property will repay redevelopment or additional expenditure. Of course, in practice he will try to pin down the risk/reward balance by working the sums on a number of differing assumptions as to rental growth and sales value.
It is also the method that a fund manager will use in trying to quantify the past performance of his existing property investments. Since it takes into account the timing of expenditures it can give a very much more precise result than any rule of thumb method. The only problem is that no calculation can be better than the assumptions behind it and, as the examples show, the assumption as to the value of the building at the end of the period is a major factor. Even when analysing past performance, there is an element of subjectivity unless the building has actually been sold.
Finally, the internal rate of return calculation allows returns on different types of investment to be reduced to a common basis, so that genuine comparisons can be made. Take a share yielding 5%, where income and capital value rise at 10% a year compound over five years. Take a property yielding 5% which shows the same rate of growth in rental value and capital value. The share will show the higher internal rate of return because the increases in dividend income are received each year (or even each half year) whereas the property owner has to wait five years for the review till he gets any increase in income at all.
