Real Estate Returns: Cash Flow, Accrual, and Gearing

Chapter: Real Estate Returns: Cash Flow, Accrual, and Gearing

1. Introduction

This chapter delves into the complexities of measuring and understanding real estate returns, focusing on the crucial roles of cash flow, accrual accounting, and financial gearing (leverage). Accurately assessing returns is paramount for informed investment decisions, portfolio management, and performance benchmarking. We will explore the theoretical underpinnings, practical applications, and potential pitfalls associated with each concept, providing a robust framework for analyzing real estate investments.

2. Cash Flow vs. Accrual Accounting

Two primary methods exist for tracking income and expenses in real estate: the cash method and the accrual method. Understanding the nuances of each is critical for accurate return calculation.

2.1. The Cash Method

• Definition: The cash method recognizes income and expenses when cash is actually received or disbursed, respectively. It’s a straightforward approach, particularly for smaller operations.

• Application: Often used in Internal Rate of Return (IRR) calculations due to its reflection of actual cash movements and compatibility with spreadsheet functions like XIRR in Microsoft Excel.

• Timing Considerations: A key decision is whether to record cash flows based on when they are due or when they are received. Best practice suggests recording rents when they are receivable.

• Mathematical Representation:

  • Cash Flow (CF)_t = Cash Inflow_t - Cash Outflow_t where t represents the time period.

• Practical Application: Imagine a building’s rent collection. A cash method system would recognize rental income only when the tenant physically pays the rent, not when the rent is billed.

2.2. The Accrual Method

• Definition: The accrual method recognizes income when it is earned and expenses when they are incurred, regardless of when cash changes hands.

• Application: Provides a more accurate picture of economic performance, especially over short analysis periods (e.g., monthly), by matching income with related expenses.

• Time-Weighted Returns: Essential for calculating accurate time-weighted returns, which require matching income during a period against expenses during that period.

• Treatment of Rent: Quarterly rent received in advance is allocated across the months to which it relates (e.g., rent paid on September 29th is apportioned across September, October, November, and December).

• Mathematical Representation:

  • Accrued Income_t = (Total Income Earned During Period) * (Time in Period / Total Period Length)
  • Accrued Expense_t = (Total Expenses Incurred During Period) * (Time in Period / Total Period Length)

• Practical Application: Consider a property with a lease signed in December, with rent commencing in January. Under the accrual method, the rental income is recognised monthly from January onwards.

2.3. Experimenting with Accounting Methods

*   **Objective:** To demonstrate the impact of accounting methods on perceived profitability and return metrics.
*   **Setup:** Create a spreadsheet model for a hypothetical property investment. Project income, expenses, and capital expenditures over a 5-year period.
*   **Procedure:**
    1.  Calculate Net Operating Income (NOI) and cash flow using *both* the cash and accrual methods. Note the differences in timing of income and expense recognition.
    2.  Calculate key performance indicators (KPIs) such as annual returns, ROI, and IRR under each method.
    3.  Analyze the impact of timing differences on the KPIs. In which situations does one method present a more favorable view of performance?
    4.  Document the results.

3. Portfolio Returns and Associated Costs

Returns from individual assets can be aggregated into a portfolio return. However, a simple combination may overstate the true return as it may not include costs that are not apportioned to individual assets. Examples of such costs are legal fees incurred on abortive purchases, portfolio valuation fees, and fund management fees.

It is important to consider the purpose of the portfolio return calculation to determine which fees to deduct. For example, if the calculation is for comparison to a market index or benchmark, the assumptions used to calculate the index or benchmark will need to be known to allow a fair ‘apples with apples’ comparison.

It is often the case that published returns indices do not include transactions and do not reflect portfolio-level costs, apart from an allowance for basic property management. Where fund management fees include property management services, the return measurer may deduct default fees from rents to provide a comparison between the performance of the underlying assets in each portfolio, excluding the impact of varying levels of fund manager fees.

4. Real Returns

Nominal rates of return do not consider the impact of inflation. Investors with liabilities denominated in real terms will be interested in what returns they achieve after the deduction of inflation.

4.1. Calculating Real Returns

Calculating real returns is simple for time-weighted rates of return. The return figure calculated can have inflation for the corresponding period deducted using the formula below:

• Formula:

  RTR = ((1 + NTR) / (1 + I)) - 1

  Where:

  • NTR = nominal total return expressed as a percentage over the period
  • I = inflation rate expressed as a percentage over the period
  • RTR = real total return expressed as a percentage over the period

4.2. Real Returns over Longer Periods

The periodic real returns calculated can be chain-linked together for calculating the real return over longer periods. For money-weighted rates of return calculated over periods longer than a year, it is more accurate to either deflate each item or stop in the cash flow by the rate of inflation from the cash flow start. The exception to this is where a constant rate of inflation over the whole cash flow is used and the formula above can be used to calculate the real return.

5. Geared (Leveraged) Returns

Borrowed funds are often used by property investors to purchase assets. This is referred to as gearing (UK) or leverage (US).

5.1. The Effect of Gearing

Gearing can significantly amplify both returns and losses. While it can boost returns when property values and income rise, it magnifies the negative impact of falling values, declining rents, or increasing interest rates.

5.2. Calculating Geared Returns

The return to an investor will be increased or decreased due to the gearing, depending on the movements in the value and income from the property.

• Scenario 1: Positive Gearing

  If the income return and the capital growth both exceed the cost of servicing the debt, gearing improves returns.
  * Scenario 2: Negative Gearing

  If values fall, rents fall, or interest rates rise, gearing can significantly reduce returns. Accordingly, taking on debt can be seen to increase the risk of an investment.

5.3. Money-Weighted Return Calculation

For a money-weighted return calculation, the calculation is simple. If the debt financing straddles the period of analysis then the debt outstanding can be deducted from the start and end valuation, with interest deducted from the intervening income. Alternatively, the points at which debt is drawn down and repaid can be treated as income and expenditure. Interest is simply a periodic deduction, with interest on commercial loans generally paid quarterly in arrears in the UK.

5.4. IRR Calculation

Allowing for rent payments in advance each quarter plus interest payments in arrears, the IRR calculation produces an additional 3.5% return over and above the simple return calculation.

Market indices such as the IPD Annual Index do not include the effect of gearing and it is assumed that the return on each asset is based on a 100% equity interest.

6. Industry Standards

• Investment Property Databank (IPD): A leading supplier of property investment performance indices and property performance analysis services to investors in the UK and Continental Europe. IPD’s methods are generally recognized as the industry standard.
• Global Investment Performance Standards (GIPS): Voluntary standards published by the Chartered Financial Analyst Institute (formerly known as the Association for Investment Management and Research). The GIPS standards are based on the underlying principles of fair representation and full disclosure.

7. Indices and Return

Indices provide a way of recording performance data through time. Using a base of 100 at a given point in time, an index records the compound growth or return of a variable such as consumer prices or the stock market. Indices provide a method of comparison irrespective of the units in which the underlying variable is measured.
Published market indices for total returns usually ignore transactions.

7.1. Property Indices

While indices of capital growth and total return have existed for the equity and bond markets for many years, property indices are a relatively recent development.

8. Conclusion

Understanding cash flow, accrual accounting, and gearing is crucial for accurately measuring and interpreting real estate returns. By carefully considering the nuances of each concept and applying appropriate methodologies, investors can make more informed decisions and manage their portfolios more effectively. Understanding the limitations of each approach and potential biases is also essential for realistic assessment and benchmarking.