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October 28, 2019

Does Return on Investment Tell the Whole Story?

Does Return on Investment Tell the Whole Story?

For real estate investors ROI is just the beginning. 

Most investors are likely familiar with the financial ratio that tells them their return on investment.  It’s a very straightforward financial ratio because its name says it all: ROI is return on Investment. It tells you how much money your investment made after its terminal value (the amount of money realized upon sale) is known.  The calculation to determine ROI is equally straightforward. It’s the amount you made on the investment less what you paid for it, divided by that same original investment.

For example, if you invested $100,000 in an apartment building that two years later you sold for $150,000, your return on investment would have been 50%.  You made $50,000 on your $100,000 purchase. 

What Does ROI Tell an Investor?

ROI is really good at explaining profit in terms of investment return.  However, it does so only in an absolute sense. It says nothing about that return relative to similar investment alternatives.  ROI is not an informative metric if you’re comparing one investment to another. For real estate investors, there’s another shortcoming of ROI. 

It tells you nothing about how your investment performed over time.  ROI doesn’t take the time value of money into consideration. While ROI is great at telling you your absolute return, it can’t tell you anything about whether that return is inferior to, on par with, or superior to something else you could have bought.  This is especially the case if your investment generates different cash flows over time.

Let’s say the apartment building you bought started to throw off cash from rents a couple of years after you bought it.  During the time you own the building, you collect a total of $166,000 in rent.

ROI would tell you that your investment returned 216%.  That’s determined in three steps. Take the sum of the rent plus what you receive when you sell the building.  From that, you subtract the $100,000 you paid for the investment. Then, divide that difference by your initial investment (again, that same $100,000).  The result is your ROI.

What is The Main Deficiency of ROI?

The important point about ROI is that it doesn’t change regardless of when those rents came in.  For example, if you started collecting rent in the year you bought the building, your ROI in the tenth year would still be 216%.  No matter how you mix or jumble those cash flows, ROI will always deliver the same result.

The problem with this is that it’s not a true reflection of how your money was working for you.  ROI tells you nothing about the relative attractiveness of those cash flows. Luckily for savvy real estate investors, there is another profitability ratio that fills this void.

Cash Flow Analysis is All About Timing

Internal Rate of Return (IRR) is often used in conjunction with ROI because it computes the rate of return for all separate cash flows over the life of the investment.  For IRR, the timing of those cash flows is important because of the time value of money. Cash flows early in the life of the investment are worth more than those that come later because they can be put to use elsewhere earning interest.

IRR tells you what the computed discount rate would have to be if you made the net present value of the difference between all future cash flows and the original investment zero.  In other words, it calculates the interest rate necessary to generate the actual (or expected) cash flows. 

To illustrate this, we’ll assume the same apartment building as in the previous example, but we’ll change the order of the cash flows.  Using the original fact pattern we see that the IRR of this investment is 19.08%.[1]

If we change the timing of the rental income so that it comes to us a year earlier than in the original example, the ROI stays at 216% but the IRR increases to 22.04%.  The reason for this is that the cash flow in year two is worth more than it would have been if it was received a year later because it would have been discounted back only one year instead of two. 

IRR tells us the rate of return the investment offers in a way that can be compared to other similar investments.  Whereas ROI tells us how much money we made on an absolute basis, IRR tells us the exact return we’re getting on our invested capital.

The Synergy of Combining ROI & IRR

ROI is a key metric that real estate investors must pay attention to in order to understand the magnitude of an investment’s potential return on a standalone basis.  It is a great analytical tool to evaluate a short-term investment where the time value of money is not consequential. It is also a great metric to use to evaluate an investment that has immediate, regular, and predictable cash flows.  A common stock that pays a quarterly dividend is a good example of the type of investment where ROI can be employed very effectively. For real estate investors, ROI should not be the only ratio you use. 

This is especially the case if you are considering more than one project.  Investing in a building that is not yet stabilized or a project that is yet to be built, under construction, or requires renovation will require an IRR analysis to determine the relative attractiveness of the anticipated cash flows.  It is also an imperative metric to use when comparing investments that offer varying cash flows over time. 

So, while ROI and IRR look at the same information they deliver completely different results.  Each should be employed when considering any real property investment.


[1] Here’s what the calculation looks like in Excel: =XIRR(Cash Flows, Dates).  Cash Flows and Dates are from the columns shown in the charts above.

 

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