Income and capital gains are the two primary source of returns from real estate investment. We have outlined the key drivers of property returns over a holding period that applies not only to Australian real estate but across all investment asset classes. In addition to these key factors in making up the investment return we have not gone through the risks of investing in real estate.
A common mistake made by amateur investors is not seeing property investment with high returns as either risky due to either the high rental is unsustainable (investing in mining towns) or limit number of natural buyers when you decide to exit the investment (student housing or small apartments). You can’t put risk into a property return calculator, rather you have to use your own judgement.
Rental Return Calculator
Rental return is made up of gross rental income and other payments made by the tenants such as contribution towards utility and in some cases in commercial real estate, fit out rent in lieu of tenant spending their own funds on capital expenditure.
Real estate is primarily known as a secured income product because of its rental return component which makes up the monthly and annual cash flow of the asset. The asset cash flow can be considered to be highly certain since there is a lease contract which stipulate the rent and rate of increase overtime. It is only during the period when the property is not occupied or during lease negotiation with new tenant that the income is uncertain.
Any variation to the lease will be a breach of contract and only at risk if the underlying tenant credit is poor. This is why it is crucial in vetting and qualifying tenants during the lease up period and where in some instance a discount to market rent is justified for government tenants which is able to sign extremely long leases or top tier companies which is less likely to default. In this instance, the company share price can be used as an indicator on the degree of distress.
Gross rent is only one component of the property income. Operating expenses should also be taken into consideration in calculating the rental return. Operating expenses include payments for the property managers to look after the property, costs of operating a building, valuation, strata fees if the property is an apartment, utility and water if they are not covered by the tenant as well as taxes and rates. Also in most states land tax on real estate owned by foreigners would be at a higher rate. For simplicity on a cash basis, capital expenditure can be considered a operating expense (while in an accounting sense, the operating expense of capital expenditure is the depreciation).
Gross Rent – Operating Expenses = Net Rental Return
Over time the income from the property would make up a large portion of the investment return. This is why during purchase or analysis of potential property investments that the focus should not only on what the rent is today but also the potential for the market rent for the area to increase overtime.
If the asset is located in a good area and that no new supply is expected then it is highly likely that rent will increase overtime as there is always demand for property in good areas. However if you are buying in a saturated market with room for more supply to come onto the market then it is very unlikely that rental growth will be strong. A strong rental growth profile is important as it increases the rental income over hence the investor rental return.
Real Estate Capital Gains
The difference between the sale price of an asset and the purchase price is called capital gain. It is literally the gain on the capital invested in the asset. Property capital gain is usually calculated using the net purchase price which is the price paid to the vendor with a lower adjustment for stamp duty and legal costs.
Legal costs are usually forgotten piece in cost budgeting during the purchase. For residential houses this include conveyancing and solicitor costs. Legal costs in commercial real estate include drawing up the contract which is called a sale and purchase agreement, and due diligence which is legal review of all material documents from a legal perspective.
There are also brokerage costs when it comes to selling the investment property which are typically 1 to 2% depending on the market and some legal costs.
The price after all the cost above and the original net purchase price make up the capital gain.
Real estate capital gains are not certain and the ultimate gain is only known when the asset is sold often years after the initial purchase. It is very hard to forecast capital gains into the initial purchase analysis since no one can really forecast what the market can do years down the track. There are rules of thumb or even if the purchase price is stupidly cheap for some obvious reason such as needing large capital expenditures or a a distressed sale. In most instances it is hard to come up with a reasonable exit price at the start outside of using general assumptions. On a fundamental level betting on aggressive capital gains return is to a degree reliant on the greater fool theory and in worst case leading to market bubble s(see Australian housing bubble).
Cash on Cash Return on Real Estate – A Return on Cash
Cash on Cash return is a return metric which calculate returns using the cash return of income and capital gain only. What this means is that in the real estate return calculator, the cash return of the property is the net rental income after all expenses and capex. The capital gain is only measured at the end in the event the asset is sold rather than annually where while not sold, investors can request a third party independent valuer to value the asset. The independent valuation sets the value of the asset so the investor can determine the unrealized capital gain return for that year. This combined with the cash income received over the last 12 month forms the total investment property cash on cash return for the year.
We are skeptical of valuation numbers and will not going in detail on how valuation can be gamed even if it is conducted by an independent party. The only number important to us is the sale price. Any interim valuation is used as a guide since the valuer is not actually buying it at that price.
For everyone cash in evaluating their investments. Therefore the importance of using cash on cash return in calculating return on real estate as only cash coming in and out are counted. It measures the return on the cash input into the deal and total cash return after the asset has been sold.
We have not gone into detail what makes it a good real estate investment, indicators or methods in getting the highest return from property but before going into depth it is important to understand the metrics that the incoming cash will be bench marked against. Otherwise you’re just flying blind.