Real Estate Returns: Foundations of Measurement

Chapter: Real Estate Returns: Foundations of Measurement

1. Introduction

Understanding how to accurately measure returns in real estate is fundamental to making informed investment decisions. This chapter lays the groundwork for understanding real estate returns by defining key concepts, exploring different methods of calculation, and discussing industry standards. We will delve into both simple and sophisticated techniques, covering topics like cash flow versus accrual accounting, the impact of inflation, and the effects of leverage (gearing).

2. Defining Real Estate Returns

• 2.1 Basic Definition: Real estate return represents the profit or loss generated by a real estate investment, expressed as a percentage of the capital invested.

  • Return = (Revenue Income + Capital Appreciation) / Capital Invested * 100%

• 2.2 Components of Total Return: Total Return typically comprises two primary components:

  • Income Return: The periodic income generated from the property, such as rental income, minus operating expenses.
  • Capital Appreciation: The change in the property’s market value over the investment period. Can be positive or negative.

• 2.3 The Importance of Time: Returns are inherently time-sensitive. An annual return of 10% is fundamentally different from a return of 10% over 5 years. Therefore, the investment timeframe must always be considered when analyzing returns.

3. Methods of Measuring Returns: Single-Period Returns

• 3.1 Simple Return: A straightforward calculation representing the percentage change in value plus any income received over a specific period, usually a year.

  • Simple Return = (Ending Value - Beginning Value + Net Operating Income) / Beginning Value * 100%
  • Where:
    • Ending Value = Market value of the property at the end of the period
    • Beginning Value = Market value of the property at the beginning of the period
    • Net Operating Income (NOI) = Revenue – Operating Expenses

• 3.2 Cash Method vs. Accrual Method: Choosing between these accounting methods significantly impacts return calculation, especially over short periods.

  • 3.2.1 Cash Method: Recognizes income and expenses when cash is received or paid out. It is simple and often used in IRR calculations because it accurately reflects the timing of actual cash flows.
  • 3.2.2 Accrual Method: Recognizes income when earned and expenses when incurred, regardless of when cash changes hands. Provides a more accurate picture of profitability, especially for short analysis periods like monthly returns. Rent, for example, is accrued to the months to which it relates, regardless of the actual payment date.
    • Example: Quarterly rent paid on September 29th should be split proportionally between the days in September, October, November, and December.

• 3.3 Practical Considerations for Cash Flows:

  • Timing: Decide whether to record cash flows on the dates they occur or the dates they are due.
  • Rent Recording: It is generally best practice to record rents when they are “receivable” (due) rather than when they are “received.”
  • Defaults: If a tenant defaults, any uncollected rents recorded on a receivable basis need to be written off.

4. Methods of Measuring Returns: Multi-Period Returns

• 4.1 Holding Period Return (HPR): The total return earned over the entire period an investment is held.

• 4.2 Annualized Return: Converting a holding period return into an equivalent annual rate. Essential for comparing investments with different holding periods.

  • Annualized Return = (1 + HPR)^(1/n) - 1
    • Where:
      • HPR = Holding Period Return
      • n = Number of years in the holding period

• 4.3 Time-Weighted Return (TWR): Measures the performance of an investment manager, isolating it from the impact of investor cash flows.

  • It is calculated by dividing the investment horizon into sub-periods based on the dates of external cash flows, calculating the return for each sub-period, and then compounding these sub-period returns. This effectively removes the impact of the timing of investor contributions or withdrawals.
  • Formula:
    1. Calculate the return for each subperiod: R_i = (Ending Value - Beginning Value - Cash Flow) / Beginning Value
    2. Compound the subperiod returns: TWR = (1 + R₁) * (1 + R₂) * … * (1 + R_n) - 1

• 4.4 Money-Weighted Return (MWR) / Internal Rate of Return (IRR): Measures the return earned by the investor, considering the timing and amount of cash flows.

  • MWR is essentially the IRR of the investment. It represents the discount rate that makes the net present value (NPV) of all cash flows equal to zero.
  • Formula:
    • NPV = Σ [CF_t / (1 + IRR)^t] = 0
      • Where:
        • CF_t = Cash flow at time t
        • IRR = Internal Rate of Return
        • t = Time period

• 4.5 Comparison of TWR and MWR:

  • TWR is preferred for evaluating investment manager performance, as it removes the influence of investor cash flows.
  • MWR is more relevant for individual investors as it reflects the actual return they experienced, considering when they invested and withdrew funds.

• 4.6 Experiment:

  • Simulate two investment scenarios with different cash flow timings but identical property performance. Calculate both TWR and MWR for each scenario. Observe how MWR changes significantly based on cash flow timing, while TWR remains relatively stable. This demonstrates the key difference between the two measures.

5. Portfolio Returns

• 5.1 Aggregating Individual Asset Returns: While individual asset returns can be combined into a portfolio return, this can overstate the true return if costs not directly allocated to individual assets are ignored.

• 5.2 Portfolio-Level Costs: Examples include legal fees on abortive purchases, portfolio valuation fees, and fund management fees.

• 5.3 Benchmark Comparison: When comparing portfolio returns to a market index or benchmark, ensure that the assumptions used to calculate the index or benchmark are understood to allow for a fair comparison. Many published indices do not include transaction costs or portfolio-level expenses.

• 5.4 Adjustments for Fund Management Fees: If fund management fees include property management services, consider deducting default fees from rents to provide a consistent comparison between the performance of underlying assets across different portfolios.

6. Real Returns and Inflation

• 6.1 Nominal vs. Real Returns: Nominal returns do not account for the impact of inflation, while real returns do. Investors, especially those with liabilities denominated in real terms (e.g., pension funds), are particularly interested in real returns.

• 6.2 Calculating Real Returns for Time-Weighted Rates of Return: The nominal return can be adjusted for inflation to derive the real return.

  • Real Total Return (RTR) = [(1 + Nominal Total Return (NTR)) / (1 + Inflation Rate (I))] - 1

• 6.3 Adjusting for Inflation in Money-Weighted Returns: For MWR calculations over periods longer than a year, it is more accurate to deflate each cash flow by the rate of inflation from the cash flow’s start date. However, if a constant rate of inflation is assumed over the entire cash flow, the formula in 6.2 can be used.

7. Geared Returns (Leveraged Returns)

• 7.1 The Impact of Debt: Borrowing funds (gearing or leverage) magnifies both gains and losses. The return to an investor is increased or decreased due to gearing, depending on property value and income movements.

• 7.2 Geared Return Calculation:

  • Numerator: Net Income (Gross Income - Interest Charges)
  • Denominator: Equity Invested (Property Value - Borrowing)

• 7.3 Example

  • Property Value: £100,000 (Start), £110,000 (End)
  • Net Income: £10,000
  • Loan-to-Value (LTV): 50%
  • Interest Rate: 7%

  Ungeared Return:
  * Equity Invested: £100,000
  * Net Income: £10,000
  * Return: (£10,000 + (£110,000 - £100,000)) / £100,000 = 20%

  Geared Return:
  * Borrowing: £50,000
  * Equity Invested: £50,000
  * Interest Charges: £50,000 * 7% = £3,500
  * Net Income: £10,000 - £3,500 = £6,500
  * Return: (£6,500 + (£60,000 - £50,000)) / £50,000 = 33%

• 7.4 Gearing and Risk: While gearing can enhance returns when property values and income rise faster than the cost of debt, it significantly reduces returns when values fall, rents decline, or interest rates increase.

• 7.5 Money-Weighted Return with Debt: In MWR calculations, debt outstanding can be deducted from the start and end valuations, and interest is deducted from income. Alternatively, debt drawdowns and repayments can be treated as income and expenditure.

• 7.6 Interest Rate Conventions: Note that the quarterly interest rate is generally the annual rate divided by four, not the compounded fourth root of the interest rate.

8. Industry Standards

• 8.1 Investment Property Databank (IPD): A leading provider of property investment performance indices and analysis, particularly in the UK and Continental Europe. IPD’s methods are widely recognized as industry standards.

  • IPD uses a time-weighted return methodology with a monthly frequency for calculating returns.

• 8.2 Global Investment Performance Standards (GIPS): Published by the Chartered Financial Analyst Institute (CFAI), GIPS provides voluntary standards for calculating and presenting investment performance, promoting fair representation and full disclosure.

  • GIPS requires a time-weighted rate of return using a valuation frequency of at least monthly.
  • Accrual accounting must be used for income and expenditure.

• 8.3 GIPS for Real Estate:

  • Annual valuations are acceptable if monthly valuations are impractical, but external valuations are required periodically (e.g., every 36 months, shifting towards quarterly with annual external valuations).
  • The source of valuations, manager discretion over investments, and the calculation methodology must be disclosed.
  • Real estate returns should be split into capital and income return.

9. Indices and Return

• 9.1 Index Construction:

  • Indices track performance data through time, typically starting with a base value of 100 at a specific point.
  • The index value is updated periodically based on the compound growth or return of the underlying variable (e.g., property values, stock prices).

• 9.2 Index Interpretation:

  • The percentage change between any two points in time can be calculated by dividing the ending index value by the beginning index value, then subtracting one.
  • For example, if an index rises from 100 to 115.8 over a year, the return is (115.8/100) - 1 = 15.8%.

• 9.3 Limitations of Market Indices:

  • Published market indices often ignore transaction costs, assuming a “standing investment” (property held continuously during the period).
  • Therefore, these indices may not be suitable benchmarks for actively managed portfolios.

• 9.4 Examples:

  • FTSE 100 reflects capital growth, ignoring trading costs.
  • Property indices like the IPD Annual Index record the return of standing investments only.

10. Conclusion

This chapter has provided a foundational understanding of real estate return measurement, covering essential concepts, calculation methods, and industry standards. Understanding these principles is crucial for anyone involved in real estate investment, enabling informed decision-making and accurate performance evaluation. The subsequent chapters will build upon this foundation, delving deeper into specific aspects like cash flow analysis, accrual accounting practices, and the complexities of leveraged investments.