This week, Secret Agent illustrates the importance of time value of money when investing in property.
There is a saying that money earned today is worth more than money earned tomorrow. The main reasons this is true are:
- Inflation (rising price levels deteriorate the spending power of cash)
- Interest rates (money that can be invested today earns interest, which compounds over time
- Opportunity cost (the ability to use money now rather than having to wait for it)
Let’s assume the following investment opportunity presents itself: A shop located on a popular inner North shopping strip is for sale. The asking price is $900,000 and the current tenant is paying $36,000 annually in rent (4.00% rental yield).
Is this a good investment?
If we can get an investment loan with 5.5% fixed interest and pay a 20% deposit ($180,000), a “napkin calculation” would say so. After accounting for land tax (about $2,500) and loan repayments ($60,000 per year for a 20-year loan), we expect to make about 9.75% per annum over 10 years. The cashflows are shown in Table 1.
One issue with this simple approach is that it does not account for the time value of money. In short, money deteriorates in value over time, mostly due to inflation. In the above example, we can see that all returns are made when the property is sold in 10 years’ time, while a large portion of the payment happens upfront in the form of a deposit.
How much is a net nominal cashflow of $1,266,656 in 10 years’ time worth today? We can adjust this to a present value sum by discounting the cash flow. If we assume 2.5% annual inflation, this cash flow is worth $989,510 today. In other words, $1.3 million in 10 years is equivalent to just under $1 million today.
Net present value (NPV) is the sum of all discounted future cash flows, for a given discount rate. We can then adjust the discount factor until NPV equals 0 (i.e. all outgoing and incoming cash flows over the investment period cancel each other out). This is shown in Table 2.
Note that these are not the actual cashflows of the investment, which are shown in the last column of Table 1. Rather, the NPV shows the value of each cash flow if it happened today. So, given the expected cashflows, the investment will return 8.97% per annum. While this is lower than our original estimate (almost always the case with property investments, where most or all the returns are realised when the property is sold), it is still an outstanding rate of return.
The calculations assume that annual rent increases by 5% each year, but what if rental growth is only 4%? If we looked at nominal cash flows only (no discounting), we would expect an annual 6.7% return on our investment. But running the same NPV analysis, we find that our expected annual returns are now only 3.84%. This is because lower rental income makes our investment more negatively geared and thus more dependent on the money we get from selling after 10 years. If rents can only be increased by 3% each year, the investment would no longer be worthwhile at any discount rate.
Here are some of the ways you can use the time value of money and tools like the net present value to your advantage:
1. Pay a higher deposit
The more money paid up front, the lower our loan repayments will be. Also, the total amount of interest paid on the loan will be significantly less. In the scenario above, with a 20% deposit our total interest paid on the loan over 10 years is $330,000. If we paid 50% of the total upfront, we would only pay $200,000 in interest.
2. Work out returns for best and worst case scenarios
We saw in the example how a change in one variable (expected rental growth) drastically changed our expected returns. Using the NPV method, we can set up different scenarios and work out our expected return. Some of the variables to consider when investing in property include vacancy rate, management fees (if using an agent to rent out the property) and maintenance costs to name a few.
3. Be flexible on when to sell the property
Because such a large chunk of total returns depends on the money received when selling the property, getting an optimal price is crucial. A common pitfall for property investors is selling when the market is at the bottom of a cycle. For the above example, the property is only negatively geared for the first 12 years, after which rental income is expected to exceed loan repayments. Property has always been a long-term investment asset.