knowledge into a presentation that will appeal to the owner’s
look at investment decisions is payback period. In the simplest terms, payback period (PP) is the amount of time it
takes for an investment to produce enough revenue to cover the cost, after which money is made on the investment.
THE FORMULA IS AS FOLLOWS:
savings from operation of the new unit. Here is where it gets interesting: We next need to determine from our contractor or the
unit will save in utility, repair and maintenance costs over the
existing, outdated unit.
Let’s say we learn from the manufacturer that the unit we are
manufacturer projects that the unit will save more than an average of $700 per year in electricity and maintenance costs over
with any degree of certainty what the exact savings will be for
your building—there are just too many variables.
Plugging the projected savings into our formula above, we see
that the payback period is 12 years ($8,500 divided by $700).
Is that good? The answer is, “It depends.” If the owner of the
(shorter is better of course) payback period to be a good investment, then this one would not be a winner. The minimum pay-back;period;is;different;for;every;owner.;Do;you;know;what;your
Payback period is a fairly elementary form of investment
analysis.;But;we;have;considered;it;first;here;as;a;way;to;intro-duce these concepts. Consider that we have now gone from a
decision about what costs less now to a decision about how long
it will take to recover our investment and start making money.
In this case, a payback of 12 years seems to be a bad investment. But if the unit will last at least 15 years (our existing one
has gone over 25), after recovering the cost ( 12 years), we’ll be in
positive territory. Not a bad deal.
Would a real estate investor look at two competing property
investments purely on the basis of which one costs less now? No,
they most certainly would not. Even the most unsophisticated
investor would look much beyond the immediate cost of a property and consider the net revenues over a projected hold period.
related terms will allow you to get their attention, and hopefully their buy-in.
THE PROJECT—REPAIR OR REPLACE AN
AIR CONDITIONING UNIT
Let us consider a typical project for which property managers
would seek approval: a new rooftop air conditioning unit. Assume your property is 25 years old and still has several of the
original rooftop package AC units. You have had long-standing
problems with this particular unit and have had numerous service calls on it because the tenant constantly complains that the
unit;is;not;cooling;sufficiently.;Now;your;trusted;HVAC;techni-cian is advising that an expensive component, the compressor,
has failed and needs to be replaced.
The cost to replace the compressor is $3,500, including parts
and;labor.;The;HVAC;company;is;telling;you;they;cannot;guar-antee that, even after replacing the compressor, the unit will
not have additional components fail. This type of equipment,
according;to;ASHRAE;(American;Society;of;Heating,;Refrig-erating and Air-Conditioning Engineers) generally has a useful
life of about 15 years. As stated above, this one is 25 years old. It
is well past its useful life.
The replacement unit, including the equipment itself and the
labor to haul away the old one and install a new one on the
roof—including the crane needed to do that—will cost $8,500.
and present your bid analysis to the owner, along with your recommendation to replace the unit. But she rejects your proposal
based on the information you have provided.
The owner’s decision was made solely based on which option
cost less right now. In other words, it was based on approval or
rejection of an “expense,” not on approval or rejection of an
The property may be experiencing some vacancy or has had
a lot of large repair costs recently and cash is tight. Whatever
the reason for the owner’s decision, it was clearly made without
you did not present the proposals to the owner in a way that
guided her to the best decision.
Instead of just sending the owner the comparative proposals and
asking her to bless your recommendation, consider approaching
the decision from her point of view instead. In other words, pro-pose;the;project;using;the;language;of;finance.
You know from experience that replacing a major component
like a compressor in an old rooftop unit is a bad business decision. Once an expensive piece of equipment like an air conditioning unit gets beyond its useful life, it is almost always better to replace it with a new unit. But you need to convert that
PP = COST OF THE PROJECT/INVESTMENT ANNUAL CASH INFLOWS