Too many homeowners doom their real estate investment by looking at the wrong ROI metrics...

A clear list of ROI metrics to consider in real estate investing, and how to calculate them... in normal-people speak.

One of my favorite videos is of golfer JC Anderson explaining how to hit a golf ball. Here it is for reference.

His explanation is insanely complicated! Fortunately, he's joking.

Unfortunately, when you want to learn anything about real estate investing - like what metrics to track, how to maximize the value of your real estate properties and portfolio, etc - most of what you read on the internet sounds just as complicated… and the authors aren't joking.

People then don’t understand what they read, latch onto the wrong metrics, and end up using them totally wrong, dooming their investments from the start!

With real estate metrics it’s tricky because different metrics should be used at different points. Some metrics are great for before you buy - they help with making purchasing decisions. Some are ideal for when you own - they help with knowing how your investment is faring at this very moment in time and if you should make a change or not. And some metrics are ideal for if you’re considering selling or after you’ve sold - they help with knowing how well your overall investment performed.

We recently wrote about Return on Equity (our favorite metric) and Cash on Cash Return. These metrics are great for purchasing decisions and knowing how to optimize a current investment.

Today, we’re diving into ROI or Return on Investment metrics. If you invested money into something - like a property - and then you sell or cash out that investment... how did it perform overall? What did you put in versus what you got out? What was your return on the investment?

Three common ROI-esque metrics we’ll discuss:

A pure, basic boring ROI
CAGR
IRR

We’ll keep it clear and direct - no JC Golf Swing explanations here.

First, what is a good ROI?

Any ROI calculation is going to end in some percentage return, like, “my money increased by 5% every year,” or, “after 7 years, the value of my investment increased by 80%.”

So a question always arises, what is a good return?

Honestly, that's a personal thing. It’s really about what is good for you!

For example, here are some standard returns you can expect in different types of investment. These are annual returns, or returns you’d expect every year (IE, not the start-to-finish return).

Savings Account: National Average is .06%, but Citi has one up to 1%
CD: National Average is .45% for 60 Month CD
Mutual Funds: Vanguard’s 500 Index Fund averaged 13.8% annually the last 10 years
Single Stock: Amazon’s stock averaged 38% annually the last 10 years, while GoPro’s stock has averaged -28% since it became available to the public

So, if you were to put $1,000 in a Citi savings account, after 10 years you’d have roughly $1,105 dollars. However, you instead could have bought $1,000 worth of Amazon stock and after 10 years you’d have $25,049 (we’ll discuss the math later on).

Obviously, that is a huge difference, and on the surface Amazon seems like a no brainer. However, the higher the returns, the higher the risk. Just look at the GoPro example above. When they first offered their stock to the public, they had huge positive returns. Then they crashed. High risk, high reward.

Just to see what this looks like over time, take a look at what’s called an Asset Class Return chart. Below is one of many variations.

As you can see some items - like Small Cap Equities or REITs (“Real Estate Investment Trusts”) - have huge returns in some years, and terrible returns in others. While others are more down the middle - like Bonds - where there are smaller wins but also smaller losses.

Generally, the wider the range of potential outcomes, the riskier we would consider the investment. In other words, the more risky an investment is, the more money we might be able to make if things go well, but the more we could lose if things don’t go as planned.

So your targeted return is really up to you, your risk tolerance, and where you are in life. Just don’t leave your money under the mattress - that’s the only way to guarantee you’ll lose money (more on that later).

Now, on to the ROI metrics...

Metric 1 - Return on Investment.

We will start here because it is the most fundamental and really explains what an ROI is (it is the name of this metric after all).

To calculate, you take all the value that you have gained (commonly known as your Net Profit), and divide it by all the cash you had to invest (AKA Cost of Investment). Multiply that by 100 to get your percentage. If you read our previous article on Cash on Cash, this is very similar to our Adjusted CoC.

ROI = Net Profit / Cost of Investment * 100

First, the cash you had to invest or your Cost of Investment: In Real Estate, this is basically your down payment and closing costs. If you do any major home renovations, this likely would go in here as well.

Remember, if you buy for $300,000, your cost of investment isn’t $300,000 (unless you buy without a mortgage, which you wouldn’t do of course because you read this). It is likely something like 20% down plus closing costs, so around $65,000 total.

That's your investment - $65,000. Now we need to figure out what you gained from that.

Where does the gained value come from? It is basically the sum of all your cash flows which come at three different moments: during your down payment (a negative cashflow), each month when rent is paid (ideally a positive cash flow), and when you sell (ideally a positive cash flow).

So first, the down payment. You paid $65,000 to buy the house so you have an initial cash flow of -$65,000.

Let’s say that after you bought the house, you got some renters and now cash flow $500 every month (cash flow being the rent they pay minus your mortgage payment and any other monthly expenses). You do that for 5 years and then sell.

In total, you've cashflowed $500/m for 60 months or $30,000.

After 5 years you decided to sell and you find someone willing to buy for $350,000. Well, you don’t get all that money because you have a mortgage, so some of that goes to the bank to pay off your loan. Let’s say your loan balance is now at $225,000 (remember, you did a $60,000 down payment). So you are left with $125,000 ($350K-$225K). You also owe some money for commissions and closing costs, so let’s say you finally end up with $115,000.

So total value gained is -$65K + $30K + $115K, which equals $80,000.

To find the ROI, we just compare the two: $80,000 earned divided by the $65,000 invested (times 100 to get the percentage). This comes out to a 123% return on your investment.

Naturally, you’ll want to compare this to the returns we mentioned above for savings accounts (.06%), CDs (.45%), mutual funds (13.8%), etc, however, those are in annual returns and what we just calculated above was an overall return.

Perhaps you think, “Oh, let's divide 123% by five for the five years I had the investment, so 24.6% annually, right?”

Not exactly. You’d actually have to do:

Annualized ROI = ((1 + Overall ROI)^(1 / Years)) - 1

This would give you an annual return of 17.41%. You do this because of something called compounding, which leads us to our next ROI metric called CAGR...

Metric 2 - CAGR

CAGR stands for Compound Annual Growth Rate. It addresses the problem above around compounding and takes you right to an annualized ROI (instead of an overall ROI that requires a tricky formula to find the true annual ROI).

First, let’s talk about compounding...

As a reminder, in our first example with ROI, you had a beginning investment and an ending total profit. Start and Finish.

The thing is, with most investments, you typically don’t get all that profit or value only at the END of the investment, but you get it periodically throughout the investment lifetime. If you lended money to a bank (that is what you are doing when you put it in a savings account) you earn value through interest on the money you’ve invested. If your investment is through purchasing an asset, like a stock, you gain money when that asset increases in value which is capital gains.

In both cases these increases in value can ALSO start generating more value and growth. This is called compounding.

Let’s pretend you were fortunate enough ten years ago to have bought a share of Amazon stock. In August of 2010, Amazon’s stock price was around $125 a share. Currently, in August of 2020, their stock is about $3,161 a share. If you ran the ROI formula we just described with Metric 1 without accounting for compounding (IE, dividing your overall ROI by 10 years only), you’d get a 242.9% return each year. That obviously is very different from the 38% return we mentioned at the beginning of this article.

So where did that 38% return come from? We accounted for compounding.

We could have accounted for compounding doing the two steps required in the ROI formula (first finding the overall ROI and then finding the annualized ROI), but instead we used just one step by leveraging CAGR.

CAGR accounts for this concept of compounding and generating value throughout your investment and finds the average growth rate of your investment across its lifetime. Keep in mind it has to be an average because in reality a stock’s value is constantly going up and down every second.

Here is how to calculate CAGR by hand:

CAGR = ((Ending Value / Beginning Value)^(1 / Time Period )) -1

However, calculating CAGR in Excel is even easier. You use the RRI function and enter three parameters. The first parameter is how many periods are in the investment. We want to think in terms of annual, since we are calculating CAGR where A stands for Annual. So, for the Amazon example above the period value is 10 for the 10 years.

The second parameter is the starting value and the third parameter is the closing value.

So, =RRI(10, 125, 3161) which gives you a compound annual growth rate (CAGR) of 38%.

You can check this by multiplying the $125 by 1.3813 ten times and you’ll get close to $3,161 (rounding errors account for the difference).

You can also use CAGR for real estate investments.

Looking at the example from metric one, we sold after 5 years, so the first parameter in excel is 5. Our starting value was the $65,000 in cash that we had to invest that went towards our down payment and closing costs. Our ending value is the cash we captured from the sale ($115,000) plus all the cash we earned throughout the investment ($30,000), so $145,000 total.

Plug it into excel (or calculate it by hand) and we get 17.41% - the exact same annualized return we got from our two step formula in Metric 1 when we accounted for compounding!

However, CAGR (and the annualized ROI) has two slight pitfalls. First, it assumes that all the cash earnings - your cash flow - are reinvested into the investment. Because of this, it has its second pitfall - it doesn’t account for the different periods that cash flows occur and something called the “time value of money.”

Enter IRR - an advanced ROI metric that solves all of the above issues.

Metric 3 - IRR

IRR stands for Internal Rate of Return. However, to begin, we need to talk about the "time value of money."

The general principle is that money today is worth MORE than money tomorrow.

Why?

Because money that you have today can be invested to become worth more tomorrow. Even if you didn’t invest it, inflation is going to devalue your money over time. That’s why it now costs more money to buy a burger than it did 10 years ago.

This goes back to the beginning when we talked about not putting your money under your mattress. If you do that, then that same $10,000 you have under your mattress today will still exist in 50 years, but due to inflation and everyone else investing their money, $10,000 won't be worth as much in 50 years. This is the time value of money.

So, money today is worth more than money tomorrow.

Now, in our previous ROI metrics above, a lot of money was exchanging hands at different moments in time. We did a big investment up front of $65,000 when the money was "worth the most." Then we gained $500 month after month, where each month that $500 is worth less and less. Finally, at the end, we got a big payout. However, at the end, money is worth the least because we’re at present day and our investment period (for this investment) is over.

The magic of IRR is it takes all these things - money exchanging hands at different periods of time - into consideration and finds your truest annual return.

This might sound complicated, but, again, with excel it is VERY easy to calculate (by hand it is a nightmare, so we’re not even going to explain that).

With excel, you’re going to use the same data from metric one: all your cash flows. Lay them out in a sequential manner, starting with your large initial negative cash flow from your down payment. Then you’ll have in a regular pattern all your $500 monthly cash flows. Finally, we’ll end with the cash gained from the sale.

From there, you just use excel. Enter =IRR and highlight the range and BAM, it spits out your PERIOD IRR of 1.53%. Our period is monthly because our cash flows were monthly, but we can annualize this by multiplying our results by 12 to get 18.39%.

This metric is higher than CAGR and the Annualized ROI because it accounts for the time value of money being earned early on.

One quick note - if your cash flow activities are irregular, you can actually use the XIRR function in excel instead, and include the dates of each cash flow activity.

There you have it, three ROI metrics.

So which one do I use?

If you are just interested in the overall return of an investment, use Metric 1 - ROI.

If you want to know the annual ROI and but don’t have excel handy or don’t want to get into exact monthly cash flows, use CAGR.

If you want to be more exact on your annual returns, and have excel, use IRR.

Another benefit of IRR is it can help you decide between two different investments with different scenarios and different estimated payoff periods because of this accounting for the time value of money. In the below example, even though the profit is the same for each scenario, Scenario 2 has a higher IRR because it collects that profit faster, allowing it to theoretically be reinvested elsewhere.

In the above example, we used the same time period for the two scenarios. However, another good reason to use IRR is if you happen to have two scenarios with radically different investment periods it standardizes the output to a comparable yearly return for each investment.

Final Thought.

As always, if you don't want to have to track all this yourself and then on top of that, have to know when to use what, just use the WayBoz app. It truly is the easiest way to manage how well all your properties are doing, it guides you to know what metrics to look at when, and informs you when it's time for a change to ensure you are maximizing your profits.

Our next article will be closing the loop on all these metrics we’ve been discussing the last few weeks. We’ll be sharing our secrets on when to use Return on Equity, Cash on Cash, IRR, and other metrics to make sure that retirement account of yours is regularly growing.

LinkedIn: https://www.linkedin.com/company/wayboz/

Our Blog: https://medium.com/@wayboz

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