What is Net Realisable Value & Why Property Investors Should Use it.
This article will discuss why property investors should start using Net Realisable Value when measuring the performance of their property investments.
Property Investors often use Return on Investment to measure the performance of their property investments. Return on Investment is calculated as:
Net return on rental profits before tax / cash invested into a deal
There are many advantages of using Return on Investment, such as its simplicity and that it enables an investor to compare against other non property investments. There is also a key floor which often makes it unsuitable for measuring the long term performance of investment property. This is what to measure when an investor has refinanced and pulled out most or all of their initial investment in the property?
I see investors who have refinanced their properties who like to boast how they are achieving high double digit or even infinite returns. Whilst this may be a good boost to your ego, it remains important that an investor accounts for any accessible equity within their property portfolio in order to understand the true performance. This is where Net Realisable Value comes into play.
Net Realisable Value is a conservative metric used by accountants when valuing assets. Importantly it looks at what the remaining sum is after liquidating an asset and paying all costs and ensures values aren’t overstated.
For a property investment Net Realisable Value can be calculated as follows:
Proceeds of sale
Selling costs (inc legals, agent fees etc) and tax
Including tax is important because property investors will often continue to refinance their properties, meaning that in cases the deferred tax liability if they come to sell a property can be greater than the Net Realisable Value. This is clearly not a good position to be in as it means that an investor cannot sell the asset without realising a loss and therefore must wait for the market to (hopefully) provide some capital growth.
Rather than using Return on Investment, investors should consider adopting a more conservative Return on Net Realisable Value, calculated as:
Net rental profits before tax / (sale proceeds less costs and tax)
This will ensure that performance is measured against actual realisable equity within the property and will also encourage investors to maintain discipline to not over leverage on their properties and put themselves in a difficult position where they are not able to sell without realising a loss.
Please subscribe below to access regular updates on tax and property investing.