Navigating Expected Returns and Hurdle Rates

As someone who frequently engages with property investors, I often encounter a common oversight: the absence of a clear expected return on investment.

This metric serves as a compass, guiding investors to determine the viability of their ventures. Equally important is establishing clear investment objectives. Yet, many investors seem to lack a definitive goal.

In the realm of Specialist Disability Accommodation (SDA) investments, investors often express a desire for high yields, driven by the need for consistent cash flow. However, they sometimes opt for traditional residential properties due to their perceived higher potential for capital gains. It appears that without a method to adjust required returns for risk, investors gravitate towards what feels safest. While safety is indeed appealing, excessively cautious approaches may hinder progress towards goals such as early retirement or fulfilling holidays.

In finance, we are trained to evaluate investments by discounting expected cash flows with a required return, essentially establishing a hurdle rate. If expected returns meet or surpass this rate, the investment becomes viable. Moreover, conducting sensitivity analysis on cash flows provides insights into best-case and worst-case scenarios. This rigorous process enables apples-to-apples comparisons and adjustments of hurdle rates for risk. For instance, acceptable returns might differ across asset classes, such as 4% for residential real estate, 8% for commercial properties, and 12% for equities.

However, evaluating an investment doesn’t occur in isolation. It necessitates consideration of its place within the broader portfolio and its opportunity cost — a topic I’ll delve into in a future blog post. Decisions are interlinked; one choice may affect others.

In the case of SDA investments, which are often optimised for yield, growth potential remains a factor, albeit secondary to the attractive yield. Yet, this focus on yield entails implications regarding structure and tax considerations. Similarly, investments solely targeting capital gains may lack immediate cash flow, impacting serviceability and borrowing capacity. Each investment avenue entails different levels of certainty around returns (risk), requiring tailored adjustments to hurdle rates.

In conclusion, understanding expected returns and hurdle rates is crucial for making informed investment decisions, especially in the realm of specialist disability accommodation. By aligning investment objectives, adjusting for risk, and considering opportunity costs, investors can navigate the complexities of the investment landscape with confidence.

Thanks for reading, Dave G Stewart.

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