Describe about the Analysis of Property Investment for Supply Council States.
In this study, discussion is to be made on the investment planning of an investor in property. For this purpose, the brief discussion is to be made on the investment option in the property. The present status of the investment project is also to be discussed in this part of the study. After the initial part of the study, the objectives and the frame of the investment are also to be discussed. The sources of funds of the investment are also to be studied in the discussion for the purpose of profitability analysis of the project. On the basis of the financial and non financial data, analysis of capital budgeting is required to be made. Furthermore, recommendation is also to be made for the investor in the last part of the discussion.
The proposed investment in property is to be made in the area of Newcastle in New South Wales. The present status of the investment could be said as in the planning stage. As the investor is planning to invest in the property, and has no occurrence of real investment, the investment status is to be said as in planning stage (Bierman and Smidt 2012).
The project is to invest in the property for earning rent on letting out. The investor is to buy a piece of building on the Newcastle area for let out purpose. The property that is selected for investment is located on north facing Gosford, rail and bus transport. The property has a nice view of the headlands. For the purpose of business in the property investment, the companies and the firms are required to apply to the municipal authority of Australia for legal requirements. Furthermore, property business in Australia also requires special attention, as the business is required to employ large amount of capital (Lai and Li 2014). As per the Australian Real Property Act 1900, the investors are required to fulfill the legal criteria, such as the special provisions of the property investment in New South Wales. The investors are required to disclose the funding details for such investment. The rules relating to the property investment includes facilitating the customers to get basic services like proper safety and availability of waters. Civil Law Act 2006 also forces the property owners to ensure the road facility to the customers and other users of the property. The Law of Property Act is to be obeyed by the building owners to get the registration of the building or other property (van der Laan and Teunter 2012).
In other investment criteria, the investor could invest in the stock market or in derivative market. In Australia, the stock market reflected an average return of 12% and the derivative market shown an average return of 11.5% for the last 10 years (Gigler et al. 2014). As just mentioned the real estate and the property investment project yield around 13% over the same period (Grant 2016). Therefore, it can be said that the investment option in the properties is better than the other investment options.
From the above discussion, it could be said that the investor is to set up the business of investing in property by abiding the legal guidelines of the country. As per the opinion of (Gaetti 2013), risk return analysis of a project is required to be considered by the owners in at the initial level to analyze the profitability of the project. The security factors are required to be fulfilled by the owners, as the safety factors are to be taken as the most important factor in Australia. Therefore, it can be said that the investor is required to abide by the Australian property laws with preference with the other business factors such as risk return analysis.
The investor in this project is looking for a secured long-term investment for 10 years. The investment is secured because based on the current market data the demand for rental property is very high and is expected to grow in the coming years. The property is expected to grow at the rate 5% per year in valuation so at the end of the investment life cycle the investor will also enjoy a capital gain. All this makes the property investment project attractive and safe (Finnerty 2013).
The capital for the project is to be accumulated by the owner for the purpose of investment in the property. There are two sources of funding one internal source and another external source. In the internal source, the investor has options like funding from internal source of capital and in the external source, the required fund can be borrowed from lenders. There are certain advantages and disadvantages in both the sources internal and external sources of funding. The internal source of funding is more costly as the investor cannot get tax benefit for the cost of internal sources of capital but it is the most secured way of funding a project (Sehgal et al. 2015). The external sources of funding are less costly but there is high risk associated with this type of funding. Therefore, a mix of both the internal and external sources of fund is use for financing the project so that risk and cost can both be effectively managed. The mix of financing that is used in the current property investment project is 70% own funding and 30% external funding.
Discounted Cash Flow
The discounted cash flow statement is prepared applying the concept of time value of money. The concept of time value of money states that amount of money paid or received at a future date is of more value than the amount received at the current date. The discounted cash flow statement finds the appropriate value of future cash flow at present value term. The discounting term is used because the present value of the cash flow is always lower than the future value of cash flow (French 2013). The Discounted cash flow analysis techniques are used to calculate the present value of the future cash flow of the finance and real estate project. The procedure that is used under this method for valuing the real-estate project consists of three steps. The forest step is to forecast expected future cash flow from the project. The second step is to establish the required rate of return and the third step is to calculate the present value of the future cash flow by using the discounting rate (Demong et al. 2014).
The expected future cash flow of the project is prepared by estimating a cash flow for the future period. In order to prepare the cash flow few important figures like the initial investment made, rent received, inflation rate and taxes are required. In this section the discounted cash flow of the property invest is analyzed. In order to analyze that in the given case, the cost of the investment property at New castle in New South Wales Australia is estimated to be $950000.00. The additional cost that is required to be incurred in addition to the cost of the project is $23000.00. The additional costs include $1075.00 for legal expenses, $21187.60 for the stamp duty and other government charges and $737.00 for other cost of purchasing. Therefore, the total outlay from the project is $973000.00. The funding of the project is to be done using two sources of finance that is own capital and borrowed funds (Enever et al. 2014). The funds are borrowed at the rate from 3.39% from the lenders. The expected return on capital is 1.89% therefore the weighted average cost of capital comes to 2.34%. The anticipated revenue is calculated by estimating the annual rental income which is $94656.00. The expenses that is estimated per annum is $5080.00 this include the body corporate per annum $ 1500.00, rates per annum is $1760.00, insurance per annum $1500.00 and other expenses is $320.00. The inflation rate is estimated to be 3% and for calculating the discount cash flow the inflation rate is taken, is 3%. On the basis of the above estimated revenue and expenses the discounted cash flow statement is prepared for 10 years. The analyses of the discounted cash flow statement are given below.
In the initial year, cash outlay is $973000.00 and from the next year the rent received and the annual expenditure amount is adjusted with the inflation figure. The project starts to earn profit from the first year of its operation. The actual profit from the property investment project has continued to grow from the first year until the 10th year. The discounted profit however has continuously fallen for each preceding year but it has remained positive. After conducting a thorough analysis of the discounted cash flow of the investment project, it can be said that the project is profitable and will give positive return for 10 years (Jandhyala 2013).
The discounted cash flow is prepared by applying appropriate discount rate. The discount rate chosen is dependent on multiple factors. The calculation and the factors are discussed hereafter to provide appropriate justification for choosing the discount rate. The discount rate used for evaluating the investment project is calculated by adding weighted average cost of capital, risk margin on investment and profit margin required from investment. The weighted average cost of capital indicates the average rate that is expected to be paid to the financers of the assets (Mishan 2015). The risk free rate of return from 10-year government bond is 1.89% so this is used as the opportunity cost for calculating of equity capital. This opportunity cost of 1.89% is used for calculating weighted average cost of capital. The interest rate of 3.39% taken for calculating WACC is chosen from various alternatives as shown in the appendices. Then the weighted average cost of capital is calculated and that comes to 2.34%. Then with the WACC, the risk margin is added. The risk margin is the value that takes into account the volatility of the market. The more volatility means higher risk margin and lower volatility means low risk margin. The risk margin rate that is used for the current project is 3% based on the current market volatility. The profit margin of 5% that is added is based on the general market conditions. The profit margin is the profit that is expected from the project. Therefore, the discount rate that is used for evaluating the investment property project is 10.34%. It can be seen from the above discussion that the discount rate adopted in evaluating the project is based on detailed calculation and after taking into account the general market condition.
Net Present Value
There are three different options available to investors for analyzing the project this three options are net present value, payback period method and internal rate of return. Many investors for evaluating the projects primarily use the net present value methods. It is because this method considers time value of money and it gives concrete numbers to the investors for comparing the initial cash outlay with the discounted return (Luukka and Collan 2015). The Net Present value can be defined as the difference between the present value of cash inflows and present value cash outflows. If the net present value of an investment project is positive then it indicates that the anticipated earning of the project is more than the cost of project. Therefore, it can be said that if the net present value of the project is positive then the project should be undertaken as this project is profitable. If on the other hand the net present value of the project is negative then it is advisable that investment should not be made on that project. A project with the positive NPV should be accepted and this is the basic concept for evaluating project based on net present value and this is known as NPV rule (Bozorgi 2015).
In the current property investment project the net present value of the discounted cash flow is $523248.00. Then as per the NPV rule, the project should be accepted, as the discounted cash flow from the project is positive. This positive cash flow of $523248.00 indicates that after taking into account all the cash outflow of the project from the beginning to the end of the project life cycle of 10 years the investment project is producing a positive cash inflow for the investor. Therefore, if the project is to be analyzed based on NPV then the project should be adopted. On analyzing the discounted cash flow, it is clear that the estimated payback period of the project is at the tenth year (Koudijs and Salisbury 2016). This means that more than half of the project life cycle will be required to recover the initial cash outlay. When a projected is evaluated based on the payback period method then projects with less pay back periods are accepted over the projects having higher pay back period. Therefore, the investor should appropriately analyze the project and should not base its conclusion by using only one evaluation method.
Internal Rate of Return
The internal rate of return measures the profitability of the investment project and it is very useful in evaluating various investment proposals. The internal rate of return is that discounting rate at which the present value of cash inflow is equal to present value of cash outflow. If the internal rate of return is used then the net present value of the project will be equal to zero. In general, a project with the internal rate of return more than the cost of capital is considered profitable so it will be beneficial for the company to undertake such projects. In evaluating an investment project, the investor usually establishes the required rate of return it is the minimum rate of return required by an investor (Ohman et al. 2013). If the Internal rate of return of the project is less than the required rate of return then the project should be rejected. If the internal rate of return of the project is more than the required rate of return then the project should be accepted. This is known as the Internal Rate of Return rule. An analysis of the project based only on the IRR will not give the complete picture so it should be used along with the NPV to make the appropriate decision.
In the property investment project the internal rate of return is 16.55% the required rate of return is 10.34%. Based on the internal rate of return rule the project should be accepted as the higher IRR than the cost of capital suggest that the project will be profitable.
The investment project is evaluated based on estimates. The estimates are prepared based on the current information’s available and as the circumstances changes the estimates of the projects changes (Sen 2013). The risk therefore can be defined as the difference between the original outcome and the expected outcome of the project. In the current property investment project the occupancy rate of the property is estimated to be 95% based on the current information available. If the demand of the commercial property declines in the coming years then it will affect the occupancy rate that is initially estimated. If the occupancy rate that is initially estimated changes then the cash inflow per year will also be affected. This in turn will affect the calculations of net present value, payback period and the internal rate of return thus the entire evaluation criteria will change. In such circumstances, the project that was initially thought to be profitable may due to changed circumstances become loss making. The risk that the actual outcome of the project may differ from the original outcome is inherent in every project evaluation (HÅ™ebíÄek et al. 2014).
In general, the risks of investing in rental property are discussed below:
There is a possibility that the property could be rented to a bad tenants. That means irregular rent, damage to the property etc.
There is also a possibility that there may not be any tenant available. Then at that time the property will only have cash outflow but not cash inflow.
The expense could grow beyond expectations then at such circumstances the expense will be more than the expected so it could be more than the rent.
The value of the property may fall due to changing circumstances.
The analysis of the property investment project in New South Wales has shown that a property in that area will cost $950000.00. In addition to this, another $23000.00 will be required to complete the project. Therefore, the total cash outflow will be $973000.00. The annual rental income of the property is $94656.00 and it is adjusted in accordance with the inflation rate (Zhou 2014). After analyzing the statement, showing the calculation of the net present value and IRR it can be seen that the project has a positive net present value of $523248.00 and the IRR is 16.55%. As can be seen both the indicators shows a positive sign except the fact that the pay beck period of the cash flow is in 10th year.
In Australia, there is a housing shortage. The report of the National Housing Supply council states that enough houses are not being built by the private and public sector. It is therefore estimated that rental charge will grow as the demand for house increases. The investment in property is a strategy for long-term wealth creation and it can provide consistent return to the investor. Based on the above analysis of the discounted cash flow statement of the project and after evaluating the net present value and the internal rate of return of the project it is recommended that the property investment proposal should be accepted. The current real-estate market in Australia is showing continues growth but if the market slows down and occupancy rate dips. Then as the property is in prime area and it is estimated that the value of the property will increase by 10% so the property can be easily sold and the investor could make reasonable profit by timely existing the loss making investment. The list of recommendations that an investor should follow for the property investment are given below:
- Investor should arrange own fund for investment.
- Investor should arrange the additional loan fund required.
- Investor should arrange for a lawyer to take care for all legal formalities for the property.
- Investor should make advertisement for tenant.
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