Be it private investors or institutional investors, the decision to invest in real property, or otherwise, should be based on sound, justifiable investment analysis and processes. Investors with investible funds have an array of financial instruments and investment vehicles to choose from. The decision to make an investment in real estate asset should be seen in light of these competing investment choices so as to make an informed decision that is optimal, taking into consideration potential returns vis-a-vis these alternatives and how the returns of these asset classes, over the long term, correlate with each other.
Without going into the details of the investment management processes adopted by institutions, it is instructional for private investors to adopt quantitative approaches usually used by these institutions to make investment decisions.
Return on Investment (ROI) Based Exit Strategy
The ROI measure of investment returns sums up all the annual operating income of a property and, together with the capital gains achieved at the end of the investment horizon until the property is disposed, compares this sum with the initial outlay that was incurred to put this investment into place, including the purchase price of the property and other related acquisition costs.
ROI = ( ∑(annual operating income) + Capital Gain) / Initial Outlay
The level of ROI very much depends on the length of time the asset is held and a 5-10 year holding period is usually needed before substantial capital growth can be realised, subject to market conditions.
Net Present Value (NPV) Based Exit Strategy
The NPV method evaluates the attractiveness of a property investment by discounting the streams of cash flows pertinent to the property to the present across the entire investment horizon until the property is disposed. The rate used to discount cashflows to their present values is the weighted average cost of capital (WACC). The costs of capital in question here is the debt financing rate, or mortgage rate, as well the rate of return usually generated for the equity portion of the investment for a specific investor. The sum of these present values are then compared with the initial outlay or investment.
NPV = ∑(PV of cashflows) – Initial Outlay
If the NPV or Net Present Value of the project, is greater than zero, the investment is then considered favourably. Otherwise, the investment should be avoided.
