Payback periods – revisited
In this article, as part of the 15th anniversary celebrations, Donna revisits one of our most controversial blogs which was generated in response to the frequently asked question ‘what is the payback period of the project’. At the time, the article was challenged for not considering total life cycle costs. So, we’ve asked her to explain a little about life cycle costing, why the post only focused on payback periods and what updates she thinks are needed…
“In accounting terms life cycle costing is about assessing all the financial implications an asset will incur over its lifespan. So this includes all initial investments; future additional investments, such as replacing tech; recurring costs, including maintained and running costs; right through to salvage and disposal. Given the nature of our work, this isn’t something that our clients ask us about, they are interested in the financials in relation to the time they will be living in the home, so payback seemed the most appropriate calculation. It’s also the only method we’ve specifically asked about.
The post focused on the single question about financial payback, without considering improved comfort, health or the environmental benefits of Passivhaus, which have all been covered by many academic papers. Really we were highlighting the subjective nature of investment payback periods, hoping to help people to identify their individual drivers behind the question.
It’s always difficult to reread something, there’s always room for improvement. Since writing there’s been a lot of data around the added value of energy efficient homes, for example Rightmove have seen an average increase of £56,000 after improvements and with the wholescale adoption of the Passivhaus standard in Scotland we’ll see a lot more data soon. The increased uptake of the standard is predicted to bring the uplift costs of building to Passivhaus down to just 4%, so it will be interested to review again in a few years time.”
The original post…
Many people ask us ‘what the payback period of their project will be’. In essence a simple question but answering raises several issues. What to include in the calculation? What discount rate should be applied? How do you cost each element? Some elements cannot be objectively costed. Even financial experts debate the value of calculating payback periods. Assuming you arrive at a figure, what is considered a good payback period when investing in property?
Financial books offer a deceivingly simple equation to estimate payback periods which assumes constants. Unfortunately, constants don’t happen in property. If we consider initial investments there are the simple elements like the up-front costs of the project, but going forward maintenance, finance and service charges vary.
Investment Payback Period = Initial Investment Capital/Annual Cash Flow
So where to start? Firstly, we need to decide our rationale for the investment, are we looking to improve our comfort, cut our carbon footprint, work from home, reduce our fuel bills, stay in the family home, make money or something else. Being clear about this will help to include the right information in the calculations. Usually there are a combination of drivers, requiring a compromise, understanding this can help us to achieve a compromise that we are content with throughout the project and beyond. Knowing your drivers will also help to clarify what is an acceptable payback period to you. If you are looking to stay in the family home forever, 40 years may be acceptable, but not if you are retiring to the coast in 12 years, three months and six days.
Let’s assume that we have a contract sum of £250,000 as our starting point, this includes the build, the contractor, professional and legal fees and warranties plus kitchen, bathrooms and toilets. Will you add to this figure the cost of new carpets, decoration and a garden make-over? Some people do as they would not have been required if room sizes did not change, others do not because these items would have needed to be funded anyway.
What about if you are moving, do you include the solicitor’s fees, stamp duty and removal costs? What if the move was about getting to the right school catchment area, do you still include the costs? If you are not moving, but renovating to get the space you need; do you reduce your initial investment capital in the equation by the savings you have made by staying put?
Your project will add value to your property, especially if you are adding space, improving an awkward layout, or renovating and modernising a run-down house. A local estate agent should be able to help you calculate a new value, considering local conditions. Environmental enhancements are more difficult to calculate, there is some evidence that environmental and thermal improvements add a premium, but the UK market is still fixated on number of bedrooms meaning that the impact is currently only marginal. For ease of calculations you may wish to reduce the initial investment capital by the increase in property value, or you may wish to increase the annual cash flow in year one or the planned year of sale by the increased value.
Maintenance can either be reduced from your initial investment capital, if the project is covering something that needs work now or added to the annual cashflow to reflect the savings from undertaking the work now. The question is how much to allow for house maintenance year on year. A quick search of the internet shows figures from an unrealistic £500 to an eye watering £14,000. A more realistic figure is probably between 1% and 4% of your house value depending on location, property and DIY skills. You will still need to undertake some maintenance; we always recommend regular servicing and you may want to change paint colours but the big ticket items will have been undertaken during the renovation and will not be required for decades.
The most obvious financial saving on an energy efficient renovation is fuel bills. This can be savings on utility bills, directly through using less heating and indirectly through generating excess energy via solar arrays. If you opt Passivhaus Plus or Passivhaus Premium you could run your electric vehicle, power the house and generate a return from the excess energy you produce. As fuel bills rise, even with a weak oil price, both in real terms and relative to income your payback period will be reduced. If you are looking at increasing your time at home either through homeworking or retirement, then the proportional saving will also increase with the need to keep the property warm more of the time.
If you are looking at funding your investment through a loan, mortgage or another financing arrangement you
will have already calculated the costs of the agreement, these can easily be applied to the calculation. If you are looking at utilising savings, you will need to consider the impact on loss of income in terms of interest payments and adjust the annual cash flow accordingly.
The more subjective elements of the equation can only be calculated on an individual basis, these are the amounts that you are willing to pay for peace of mind for reducing your fuel bills now when interest rates are low meaning that you protect your income during retirement. The ability to sit comfortably reading your favourite book on a cold winter’s day next to a stunning view. The ability to live in your family home as you future proofed with downstairs amenities. Being able to cut out the commute as you have created a productive workspace. The knowledge you are surrounded by healthy, low carbon materials, which research is increasingly linking with improved health of residents, reduced ill-health and less time off work/study/leisure interests. All of these items can only be priced by an individual. The figures may outweigh any financial considerations, be nil or anything in between.
So, as you can see, payback periods is a very subjective question, with many personal elements meaning that even the same project might be costed differently. So, it is really important to speak with the other decision makers to make sure that you each understand where you are coming from.
If you would like to hear more about carbon payback periods check out next month’s blog.
