Using the IRR to Measure Real Estate Returns for a Seller
I have done a lot of spreadsheets for clients about to purchase residential or commercial property—to give them some idea of the rate of return they can expect in the future. But I recently had the opportunity to do one for a couple of investor friends of mine who were thinking of divesting one of their residential properties by looking back to measure their return on investment.
The subject property is on a nice residential street; has five bedrooms and two full baths; it is rented out to students from a nearby university on a room by room basis. Because of this, they are exempt from Ontario’s RTA (Residential Tenancy Act)—they are free to raise rents as they see fit and evict roomers with a minimum of fuss if they are troublesome.
They are active Landlords in the sense that they are over at the rental property at least once a month and they keep a close watch on their tenants. They paint each room when it becomes vacant and have a good relationship with their tenants.
We prepared a CMA (Comparative Market Analysis) for them and the value of the property, based on what comparable homes have sold for in the neighborhood in the last eight months, was estimated to be between $289,000 and $299,000. They were not particularly happy with the news that their property had not appreciated more.
In fact, they looked at it this way: the property had ‘only’ increased in value by $19,826 after deducting prospective agency fees for listing and sale plus closing costs (basically legal fees). With a purchase price of $262,000 in 2005, this seemed to our clients like a pretty puny increase in the four years that they had owned it. By their calculation, they had only seen a return of around 2.8% p.a.
(The subject calculations are shown below. For a more useful tool, you can download the spreadsheet in .xls from my server.)
Now these folks are bright, talented people but the analysis they did on the spot was far from complete. First of all, they will make (assuming that it sells in the range we expect it to) $19,826 not on the original purchase price of $262,000 but on the cash equity they actually put up to buy the building, which was $65,000. So right away, the rate of return jumps significantly from 2.8% to 6.88% p.a. Not especially great but certainly better than you could get from your bank or on a T-Bill or from a Term Deposit (maybe you would get 2.5% on a $20,000 Certificate of Deposit these days).
Next, they had forgotten that they were cash positive throughout—their cash on cash return amounting to an average of about $645 per month. This yielded them a second return on their equity (ROE) of an additional 11.9% p.a.
Lastly, every month that they owned the house, their tenants were helping them to pay down their mortgage. This is a wealth effect or, in an owner-occupied building, a form of forced savings. This amounted to another $18,911 paid off during their ownership period—a third form of return. Their ROE from this is around 6.6% p.a.
So if we now simply add up their three types or return (real estate inflation (all of which goes to the equity holder and none of which goes to the mortgage company), their cash on cash return plus the benefit they receive from the paydown of their mortgage), we get an estimated total ROE of 25.4% p.a.
Now this is just an estimate; to get a clearer picture, we need to use a somewhat more advanced technique—we need to measure the IRR (Internal Rate of Return) for their project.
When we do this, the IRR comes out a little bit lower: it is 22.6% p.a. (The reason it is lower than the ROE is because the IRR calculation properly takes into account the time value of money. For example, a cash on cash return of $7,744 is more valuable to our investors in year one than in year four.)
But still, a 22.6% p.a. is a lot higher than what you could get at your Bank and a lot more than their initial view that they had only seen a return of 2.8%. (It is also a heck of a lot better than they did with their stocks and mutual funds which last year and this year alone had dropped 29%.)
Now there are a lot of assumptions that are implicit in these calculations like, say, we did not put in a fee for their monthly management of the building. Also, there is very little in here for marketing. (It turns out that Kijiji and other free websites were pretty much all they needed for this well located property.)
But if the alternative was sitting on the couch watching more TV, we can be forgiven for this oversight.
The happy news is that the spreadsheet gives them confidence that, if they do decide to sell, they have done not so badly after all.
Prof Bruce
Ps. It is also interesting to note that the Cap Rate (Capitalization Rate = NOI/SP, where NOI is Net Operating Income and SP is Selling Price) is just 8% p.a. Cap Rates are a rule of thumb that has a lot of traction in the R. E. biz but it does not capture real estate inflation nor does it take into account the wealth effect from forced savings/paydown of the mortgage so it is a very limited tool indeed. To properly inform a client of their prospects in real estate, the IRR is a preferred method.
Pps. The numbers and facts have been changed somewhat to protect the identity of the property.
Ppps. Note that this analysis is done before tax. Since tax calculations can be complex and highly subject to individual situations, each reader is advised to look at the tax implications of asset selling with their accounting advisor.
129 Anywhere Crescent Confidential
Purchase Price $262,000 2005
Equity ($65,000)
Mortgage $197,000
Rental or Imputed Rent $2,200 per month $550 per month 4 bedrooms
$26,400 per year
Property Taxes ($2,489) per year 0.95%
Vacancy ($1,452) per year 5.50%
Marketing ($118.80) per year 0.45%
Insurance ($1,310) per year 0.50%
NOI $ 21,030.20 per year
Cap Rate 8.0% per year
IRR
Equity ($65,000)
Mortgage $197,000 4.50% 25 year amortization
($1,107.12) per month
($13,285.49) per year
Year
0 ($65,000) 2005
1 $ 7,744.71 2006 $ 645.39
2 $ 7,744.71 2007
3 $ 7,744.71 2008
4 $111,483.12 2009
IRR 22.6% per year cash on cash return + real estate inflation + forced savings (paydown of mortgage) Total Return
$ 30,978.85 $ 19,826.71 $18,911.69 $ 69,717.25
Principal Repaid ($4,420.49)
($4,619.41) Original Equity $65,000 $84,826.71
($4,827.28) Real Estate Inflation $ 19,826.71 (net of realty fees and closing costs)
($5,044.51) ROE(1) 6.88% $ 84,820.17
Total Principal Repaid ($18,911.69) Cash on Cash $ 7,744.71
ROE(2) 11.91%
Paydown of Mortgage $18,911.69 $83,911.69
ROE(3) 6.60% $ 83,934.82
Real Estate Inflation 3.25% per year 25.39%
Selling Price $297,756.69 after 4 years
Real Estate Fees ($14,887.83) 5%
Legal Fees & Closing Costs ($1,042.15) 0.35%
Net Selling Price $281,826.71
E&OE