07 Oct 2013
Words Tim Admin

Investment Return Basics Explained

If you are seeking to buy an income producing asset you will surely look at more than one at which stage I’m sure you will make comparisons. While physical presentation, state of repair and location are all important ultimately you are buying an income stream so best to have a mechanism for comparing. The cash flows and profits associated with management rights are generally sold on a multiple of net profit while motels and caravan parks are sold on a yield or return on investment. The multiple usually quoted for a management rights can easily be converted to a yield which can be useful when comparing individual opportunities. For what it’s worth I believe in calculating return on investment for management rights on the total purchase price, not just the business price. The calculation for return on investment is pretty simple: Example 1 Unit $500,000 Management Rights $1,500,000 Total $2,000,000 Net Profit $300,000 Multiple 5 times Return on Investment (Yield) 15% Example 2 Unit $700,000 Management Rights $1,300,000 Total $2,000,000 Net Profit $270,000 Multiple 4.8 times Return on Investment (Yield) 13.5% Example 3 Motel lease $2,000,000 Net Profit $560,000 Multiple 3.57 times Return on Investment (Yield) 28% As we can see the relative ratio of unit to business value combined with the lower multiple for the lower net results in an overall fall in ROI to 13.5 in example 2. The same calculations for a typical large motel lease reflect the fact that there is no real estate component being purchased, just the cash flow business. Arguably motel leases may carry some additional risk and responsibility, hence the market expectation of a higher Return on Investment. Of course, nearly everyone who buys one of these assets borrows and here’s where the miracle of using someone else’s money comes in. Rather than looking at Return on Investment let’s have a look at Return on Equity. In this calculation we are interested in understanding what return on the capital employed by the purchaser rather than the return on the total purchase price. This is an excellent first step in better understanding your return as compared to other investments you could have taken up, such as shares or a simple bank term deposit. Using Example 1 the Return on Equity numbers look like this: Total purchase price $2,000,000 Estimated Costs $100,000 Total Required to Complete $2,100,000 Borrowing $1,400,000 Interest Only Purchaser contribution $700,000 Averaged Interest Rate 7.5% Net Profit $300,000 Annual Interest Cost $105,000 Net Profit after interest $195,000 Return on Equity 27.86% What we are seeing here is a simple case of the benefits of leverage in a relatively low interest rate environment. Of course, if rates were to rise with no commensurate lift in Return on Investment then Return on Equity would fall. It’s also true that for some assets such as motel leases interest only terms are difficult to come by so the actual debt servicing impact on cash flow is higher. As debt is paid down the operator’s equity position grows and thus Return on Equity is impacted. I am a great believer in always comparing any business investment with the rate you would achieve if your money was simply deposited with a bank. This tends to give a low risk benchmark when seeking to understand the whole Investment and Equity Return dynamic. Ultimately risk and return are interlinked with the general rule being the higher the risk, the higher the appropriate return. Some might argue that within the accommodation sector the returns are encouragingly high for a generally lower than normal business risk. Most everything we buy these days is funded with either debt or equity. For the most part we no longer exchange goods and services for value and in any event I suspect the tax man would frown on such practices. Put simply, debt is the bank’s money and equity is yours. Provided the bank’s money is cheap enough and the investment return good enough then sometimes better the bank’s money than your own.