Evaluating the growth and return on equity achieved over the preceding 12 months or 12 months from the date of settlement is done by ascertaining the current market value of the property and comparing it with the original purchase price.
Current market value can be determined by evaluating directly comparable properties, which have sold within three to six months of the review date against the prospective investment property. Between three and five comparable properties will be sufficient for this exercise and specific criteria should be applied when selecting them. These are:
In close proximity to the subject property;
Valuers and independent property advisors are usually well positioned to undertake this assessment.
When market conditions are subdued and market-wide growth is minimal, capital growth should at least keep pace with inflation and outpace the performance of the wider marketplace by 5 per cent to 8 per cent. During more buoyant conditions, growth performance should be at the upper end of this scale.
Rental yield should also be evaluated and this can be done by establishing what has actually been received in the 12-month period (less management and maintenance costs) to what was expected to be received. The amount of rental income should also be compared to like properties within the same area and if the investor is using a managing agent, the latter will be able to provide a comparison between the rental income from your client’s property and other investment properties that they manage.
Assess capital growth achieved in dollar and percentage terms.
One way of measuring capital growth is to measure current value against purchase value. For example, if an investor purchased a property for $200,000 in Year 1 and you have established its current value in Year 2 at $240,000, the capital growth achieved over that 12-month period is $40,000 or 20 per cent.
Another method of calculating the success of an investment is to calculate the return on equity, which is the percentage by which the property’s value has increased beyond the amount of equity originally vested in the asset.
For example, a property purchased for $200,000 with a 10 per cent cash deposit ($20,000) and an investment loan of $180,000 increases in value by 10 per cent in the first year of ownership. Therefore, the return on equity would be $20,000 or 100 per cent.
If we take the case of an investment property purchased for $200,000 with a deposit of $20,000 and a loan of $180 000, the average compound growth at 10% per annum would be as follows:
Note: Depending on the stage of the property cycle, growth rates and return on equity will vary on a yearly basis.
It is important to note that in the early years of ownership and particularly if a property has been purchased during a period of softer growth in the overall property cycle, it is possible that a low level of growth may be a result of cyclical forces rather than an indicator of a poor-quality asset. You should, therefore, treat these evaluations as informative rather than indicative.
Provided the investor has adhered to all the fundamentals of asset selection, time should be allowed to do its work, particularly if the investment is performing roughly in line with or slightly better than, the wider market. If this is not the case and the property continues to under-perform over several years despite an improvement in wider market conditions, then it may be necessary to dispose of it.
Note that the performance of an asset may also be affected by other variables, for example, changes to rental income, personal income tax, property rates and interest rates, repayment of principal on the loan balance, and other out-of-pocket expenses associated with the property itself. Accountants are best positioned to undertake the complex technical processes associated with total returns that incorporate tax issues as well as the variables detailed above.