How to annualize capital gains: Capital gains represent a very important component of the return on a property investment and they can be realized only if by the time of sale the value of the property is greater than the purchase price by more than the costs that the investor will incur in order to sell the property.
The second important component of property investment returns is the income return that is attributable to the net operating income (NOI) earned by the property.
The formula for estimating the total before-tax capital gain (BTCG) for a property investment is the following:
BTCG = Sales Price –Sales Costs – Purchase Price (1)
In order to better understand and make sense of capital gains as an important investment performance measure we need to make sure that it is expressed as an annualized rate. For most property investments it is necessary to annualize capital gains since it is rare that the time between the purchase of a property and its resale represents exactly a year. The formula for converting the capital gains estimated in (1) to an annual rate is the following:
BTCG Annual Rate= [(Sales Price-Sales Cost)/Purchase Price](1/n) – 1 (2)
In the above formula, n is the number of years between the time of purchase and the time of sale. For example, let’s assume that the property is sold 3 years and 3 months after its purchase. Then n in the above formula would be equal to 3.25. If the property is sold 2 years and 5 months after its purchase then n is calculated as follows:
n = 2 + (5/12) = 2 + 0.42 = 2.42
If the property is sold 4 years and 135 days after its purchase then n is calculated as follows:
n = 4 + (135/365) = 4 + 0.37 = 4.37
In order to demonstrate the calculation of the annualized rate for the before-tax capital gains consider a property investment with the following performance data:
Purchase price : £380,000
Sales Price : £500,000
Sales Costs : £ 15,000
n : 4.6 years
In order to annualize capital gains for this investment we apply formula (2):
BTCGAnnual Rate = [(500,000-15,000)/380,000](1/4.6) -1
= (485,000/380,000)0.217 -1
= 1.0545 – 1 = 5.45%
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