How to properly assess the return on investment in real estate?

Problems of Russian investors

In our previous analysis, entitled "Two challenges facing Russian investors: an analytical review" (2021), we noted that in addition to visa-related restrictions, many investors continue to face problems arising from inflated return expectations. In the current context, this phenomenon is no longer as significant as it was in 2014, when experts first drew attention to the discrepancies between the real conditions of foreignreal estate markets and the perceptions of investors from Russia and CIS countries. At that time, inflated yield expectations were explained by different interpretations of the term "yield" and methods of its calculation.

Operating and total return

Based on this, it is essential to clearly distinguish between two main terms:operating incomeandtotal returnThe definition of operating yield is based on net operating income (NOI), which is divided by the asset's value; this indicator can be calculated throughout the entire duration of the project. Total yield, in turn, is usually related to the internal rate of return (IRR) and is calculated over the entire duration of the project. In both cases, yield is expressed as an annual percentage, but the interpretation of these percentages can vary significantly.

Example of calculating operating profitability

Let's take a closer look at operational profitability. For example, if a rental property is worth 10 million euros and generates a profit of 750,000 euros over the course of a year, the yield would be 750,000 / 10,000,000, which corresponds to 7.5%. The value of an asset usually refers to its contractual price, but there are also various alternative valuation methods. For instance, if this property was sold many years ago, the old valuation data may be outdated, and modern appraisal methods will need to be employed.

Calculation of operating profit

Operating profit is defined as the total amount of income minus operating expenses, including:

• Management expenses;
• Utilities;
• Operating expenses;
• Marketing.

This figure is calculated before taxes, as taxation depends on the individual circumstances of each investor, while operating income reflects the profitability of the investment project itself. Such calculations can help provide a more accurate estimate of the time required to recoup the investment. For example, if a project yields 7.5% per year, the investment can be recovered in about 100 / 7.5 ≈ 13 years.

Total return and IRR

As for the total return, IRR is determined on the basis of all cash flows arising during the entire project period. The essence of this indicator is as follows: imagine that all the funds invested in the project were placed in a deposit account in a bank. What would the interest rate be in order to end up with the same return? This hypothetical rate is the IRR or internal rate of return. Having this information helps investors better navigate market conditions and avoid discrepancies between what they expect and actual results.

Conclusion

Thus, the awareness of the differences betweenoperatingandfull yieldIt becomes an important aspect that helps make informed investment decisions. This knowledge allows one to avoid unreasonable expectations and manage investments more effectively.

Introduction to Internal Rate of Return (IRR)

In the calculations of the internal rate of return (IRR), there is no single formula; however, most financial applications, including Excel, offer tools for this assessment, such as the NPV function. Let's consider a scenario where the investment object is a rental property generating an annual income of 750,000 euros, and after ten years, it is sold for 10,000,000 euros.

Conclusion

In conclusion of my analysis, I want to emphasize that understanding both operational and total returns plays a key role for Russian investors looking to effectively invest their funds abroad.

In recent years, issues with inflated expectations regarding returns have become less relevant, but it is important to remember the significant differences between mathematical concepts and real economic conditions.

Key aspects of profitability

After understanding the nuances of operating and total returns and how they are calculated, it becomes obvious that neglecting these aspects can lead to financial loss and disappointment. Operating yield allows investors to more quickly assess the payback period, while total return helps to form a more complete picture of potential profits.

Methods of analysis

I also cannot help but note that a proper analysis of profitability is not limited to just the final stage of the investment process. It begins with a thorough development of forecasts, in which all possible risks and expected conditions for changes in relevant indicators are clearly defined. In this context, the use of ready-made financial models and software becomes not just useful, but a necessary tool for anyone looking to enter international investment markets.

The uniqueness of each project

It is important to remember that every project is unique, and mapping financial flows into one universal indicator does not always give a true picture of potential returns. How we perceive and calculate these returns must be deeply customized to the specific situation, including tax considerations and financing terms.

Thus, a Russian investor, possessing the necessary knowledge about the differences between operational and total return, will be able not only to avoid common mistakes but also to significantly enhance the effectiveness of their investment strategy. I am confident that by following these recommendations, investors will be able to focus on the blurred perception of investment reality in recent years, finding a balance between expectations and real opportunities.