Beware of calculating investment returns on historic costs

 One is increasingly seeing property investments being advertised as delivering ever-improving income returns as time goes by. But more often than not, the forecast income-return calculations contain a fundamental error: they are based on historic costs, and these are irrelevant in making investment (forward-looking) decisions.

Rode’s Report editor Garth Johnson warns that this can lead to investors basing their investment decisions on false perceptions and losing out on investments that could offer them a better total return on their money.

As a simple example: the purchase price of a property investment is, say, R1 million and the expected net income return in the first year is, say, 9% or R90.000. The investor is told that, assuming income grows at, say, 7% per annum, the investment would yield an income return on the initial investment of 11,8% by the fifth year.

This is indeed very inviting, but unfortunately incorrect. The correct way to calculate income returns is, of course, to take account of capital growth (also assumed to be 7% per annum in our example) and to calculate the expected year-5 income return on the expected market value of the property at the beginning of the same year, which in our example results in a 9% income return.

This type of mistake, on the one hand, makes informed investors nervous about the competence of the promoters of such a scheme, while on the other hand it does nothing to educate the investment public.

Another snag that investors warns Johnson must be cautious of, relates to the difference between rental escalation and rental growth rates. Rental escalation refers to the amount by which a rental increases (escalates) each year in terms of a contract of lease, whereas rental growth refers to the movement in market rentals.

In the absence of a re-rating of property (due to inflation-rate changes, for example), market value should grow at a rate related to market rental growth − that is, in the medium to long term at least. Thus, when a property has a tenant with a long-term contract with an escalation rate of, say, 10%, it is wrong to assume that market value will grow at the same rate. This is so because market rentals might grow at only 7% p.a. during the currency of the lease.
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