In the previous three installments (review them here if you like: Part 1, Part 2, Part 3) we covered the most common methods of measuring the return on a real estate investment. There is yet another that is a bit more esoteric and complex; so if you’re up for it, grab your double espresso and jump in.
Capital Accumulation Comparison–CpA
Let’s say that you’re contemplating a purchase and want to decide between two properties, one requiring a cash investment of $100,000, the other $60,000. Clearly, you must really have $100,000 in hand if you’re considering both options. To make an “apples-to-apples” comparison of these two mutually exclusive scenarios, you should invest the entire $100,000 no matter which property you choose.
If that’s the case, then when you evaluate the option that requires only $60k for the property purchase, your analysis should involve both the return you expect to receive from that property plus the return you expect from the $40k cash that you were free to invest elsewhere.
Likewise, if you project that you will hold one property for 4 years but the other for 5, you should look at the after-tax proceeds from selling the 4-year property and take into account the return you could earn with those proceeds if you invest them elsewhere for one more year.
In short, you are saying that a straight-up comparison of these two investment alternatives should presume that you commit the same amount of cash in each case, and that you keep that cash committed for the same length of time.
A Capital Accumulation Comparison (CpA) is one way you might address these issues. This method allows you to compare investment alternatives not with a rate-of-return measurement but rather in terms of dollars, even if those dollars don’t remain in the original property investment.
Consider two mutually exclusive investment opportunities, Property A and Property B, with the following cash flows:
To perform a Capital Accumulation comparison, you begin by eliminating the negative cash flows as you saw in the MIRR example above. This time you choose a safe rate of 4%.
Next, you compound all positive cash flows to the end of your holding period, Year 5. You decide on a reinvestment rate of 9%.
You have one last issue to deal with: Clearly, you must be starting out with $100,000 cash in your pocket or you wouldn’t be considering the purchase of Property A. If you decide to buy Property B, then you’ll have $40,000 left over to work with. To make a true comparison of these alternatives, you need to commit the same amount with either choice. You do that by assuming that you’ll invest the remaining $40k for the 5-year holding period; for consistency, you may use your reinvestment rate of 9% as the expected return on this cash.
Your final series of cash flows, after discounting negatives and compounding positives, looks like this:
Let’s have an instant replay of what you did here, first using just Property A. If some of this is starting to sound familiar, you’ve probably noticed that this process of computing CpA looks a great deal like what you saw for FMRR in the last insatllment of our series, except instead of looking for a rate of return you’re looking for a total accumulation of cash.
In the example above, you first needed to eliminate the negative cash flow of $15,000 that occurred in year 3. You did that by discounting it back at 4% per year until its discounted amount could be absorbed by an earlier positive cash flow. In this case you had to go back only one year. Negative 15,000 discounted at 4% for one year is negative 14,423, which could be absorbed by Year 2’s positive 15,000, leaving a net for Year 3 of the difference, 577.
(If you had some amount of negative cash flow that you could not absorb into positive cash flows, you would discount the negative cash back to Year 0 and add it to initial investment amount, again as described in FMRR.)
Next you compounded each of Property A’s positive cash flow forward to Year 5 at the reinvestment rate of 9%. Why five years, when you expect to hold the property for just four? Because you’re comparing Property A to an alternative (and mutually exclusive) investment that you would hold for five years. So to keep the alternatives in balance you need to keep your EOY 4 money in play (at the reinvestment rate) for the same amount of time as in Property B.
When you were done, your entire accumulation was a combined negative 100,000 and positive 281,287, or 181,287.
Property B worked the same way, but required one additional step: Equalizing your cash commitment by investing elsewhere the $40,000 that was not required to purchase Property B. By investing that $40k, you were able to compare two investment scenarios, each requiring $100k of cash.
As you can see, the total capital accumulation for Property A ($181,287) is greater than that for Property B ($163,815), so Property A is your preferred choice according to the CpA method. Interestingly enough, if you were to do an IRR on the original cash flows, you would find that Property B, with 33.7% is greater than A’s 30.0%, while the B’s MIRR of 25.2% wins by a nose over A’s 24.8%.
Why might that be so? The answer should lie in one or both of the “equalizing” factors: holding period or initial investment. Perhaps in this example $40,000 is working harder for you invested in Property A than it is when invested independently if you chose Property B.
As promised in Part 1 of this series, we’ve really stirred the alphabet soup – NPV, PI, IRR, FMRR, MIRR and CpA. Is CpA a silver bullet? Indeed is any one of these the only measure you’ll ever need?
Probably not. They all require judgments on your part – about cash flows, resale proceeds, perceived risk, and sometimes discount rate, safe rate or reinvestment rate. In regard to any specific deal you may be more confident about some of these judgments than you are about others, and that confidence – or lack of it – can influence how much you want to rely on any one metric. The smart investor will understand them all, consider them all, and use the one (or several) that seems best suited to the actual investment decision at hand. After all, you wouldn’t keep just one kind of screwdriver or one size wrench in your basement toolbox. Do no less with your investments.
P.S. If the calculation of CpA is not your idea of fun, RealData offers an add-on module to its Real Estate Investment Analysis, Professional Edition software that will do the heavy lifting for you.
Your time and your investment capital are too valuable to risk on a do-it-yourself investment spreadsheet. For more than 30 years, RealData has provided the best and most reliable real estate investment software to help you make intelligent investment decisions and to create presentations you can confidently show to lenders, clients, and equity partners. Learn more at www.realdata.com.
Need to calculate Capital Accumulation Comparison (CpA)? Use the Comparison Add-on for Real Estate Investment Analysis, Professional Edition.
Copyright 2008, 2014, Frank Gallinelli and RealData® Inc. All Rights Reserved
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