Simple Payback Period (SPP) is a metric that all too many prospects are tempted to use when deciding whether or not to fund an expense-reducing capital project. As many of you already know, I am not a big fan of SPP. In most cases, it’s far too simple a tool to evaluate proposed projects accurately. Here’s an example where relying on SPP along would clearly steer you wrong:
Assume a landlord realizes that he’s paying too much for utilities in his master-metered, gross-leased building. He’s considering investing $1.00 per square foot in an expense-reducing capital project that is projected to produce $0.25 per square foot in utility savings. One would be tempted to say that the arrangement would be a four-year payback, right? Well, maybe not. It would be a four-year payback based on utility cost savings alone. However, what if the landlord planned to have the building appraised the very next year for refinance or sale?
Guess what? The extra $0.25 a square foot in utility savings would increase the landlord’s net operating income by that same amount. Moreover, the bigger news would be that, assuming a 5% capitalization rate, the appraiser could now justify adding an extra $5.00 per square foot to the property’s value. Why? Because $0.25 divided by that assumed cap rate of 5% increases the value of the building by $5.00 using the Direct Capitalization variety of the Income Approach to Appraisal. That bump in value equates to five times the installation cost!
That said the fact that the higher appraised value doesn’t happen in the first year would place it outside the realm of the simple payback period calculation, which only focuses on cash flows that occur in Year 1.
What if the landlord is laboring under the impression that the investment would have a four-year payback when in actuality, he would enjoy five times his money back as soon as one year’s set of books reflect the higher NOI and he has the building reappraised? Focusing on the simple payback period and remaining blind to the most important part of the equation – the potential bump in appraised value – could lead a landlord to make the wrong decision.
So, what’s the moral of the story? Take a look at the bigger picture before you present a financial analysis to your prospect. Show them why it doesn’t make sense to evaluate their investment with something as simple as simple payback period.
