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How Do You Know if Your Real Estate Investment is Performing
In these difficult times, most people are starting to feel the squeeze in their pockets and feeling strongly that their investments are not performing as well as they should.
How do you tell what good performance is?
Needless to say, there are the most obvious measures: Cash flow positive, profitability and sustainability; basically, is your investment surviving, at a minimum.
All these methods have one thing in common; they assign all the costs to the property, which are incurred in the investment. Therefore, slowly but surely, due to the interest rate decreases; properties will start to be cash flow positive again.
So how do we really rate the profitability of an investment? From a financial perspective, the starting point would be the income statement.
Revenue versus gross profit:
The gross profit figure (Revenue less cost directly related to generating revenue) is the first matter of business. This figure, expressed as a percentage of gross revenue, tells us how profitable we are in the "front-line". The front line would be the direct profit generated by the business, without the supporting structure.
That's where the "net profit" figure comes in. The net profit takes into account costs related to the structure. In the property market, these would be telephone costs, TPN searches, and the costs of show days, levies and many more.
However, it is not just good enough to look at this one figure. Bottom line thinking can lead to unnoticed decreases in profitability. Hence, in finance, the primary considerations would be "Return on Assets" (ROA) and "Residual income" (R.I).
Why use these methods?
The primary objective of these methods is to detect inefficiency. The idea is to look at the profit you are making, given the asset base available. For example: If two investors both have profits of 40,000 per month but the first investor generates it using assets worth five million while the second has assets worth ten; it is clear to see that the first investor is way more efficient in the use of his assets.
The first Investor's return on assets would be 0.8% (40,000/5,000,000 x 100) while the second's would be half that.
This profit performance can also be measured in another way. RI involves knowing the concept of "Cost of Capital".
What residual income basically calculates is a Rand value added to your business through use of the assets (how much cash flow is left over after incurring the cost associated with maintaining the assets or after deducting the cash flow return required on the assets). This involves decreasing the profits by the Rand cost associated with maintaining your capital investment. In this case, that cost would be interest.
Suppose you have a bond on your assets at 15% per year. The asset value is 5,000,000 and the profit for the year is 1000,000. The R.I formula is: Profit - (Asset value x Cost of capital). In this case it would be 1,000,000 - (5,000,000 X 15%). Giving us 250,000. This Rand value is the physical economic value added to the business.
Please note that this is not financial advice in any form. The data in this article is informational only for property investors to illustrate tax issues. If you need financial advice refer to a professional that can assist you with your particular circumstances.
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