Real Estate Investor Series Part 8: Types of Returns
There are many ways to skin a cat. This common term makes its way back a couple centuries. Roger Schlueter’s research on this saying explains discovered the following:
The most interesting discovery I made was that the people who began using the phrase seemed to be equal-opportunity animal abusers (in their speech, at least). Way back in 1678, English naturalist John Ray may have provided the earliest written version in his “Collection of English
Proverbs”: “There are more ways to kill a dog than hanging.”
But by the 19th century, the tide had turned decisively against poor Kitty. In 1840, American humorist Seba Smith indicated as much in her short story “The Money Diggers” when she wrote: “As it is said, ‘There are more ways than one to skin a cat,’ so are there more ways than one of digging for money.”
What is most intriguing is the second half of the statement about skinning cats which states “so are there more ways than one of digging for money.” There are many ways to make money in real estate and there is more than one way to calculate how hard your money is working for you. Smart investors are always seeking ways to have your money work for you day and night.
So how do you know how hard that money is working for you? This is calculated in your returns.
HOW ARE RETURNS CALCULATED?
It should be as simple as how much money you make compared to how much money you put in, right? That is correct, but there is more to it than that. Several factors play into the returns other than money in versus money out. These include:
Timing of the returns
Length investment is held
For the reasons above, there are several ways to calculate the returns earned on an investment. This is no different with real estate investment. Let’s cover some of the more common types of returns you’ll find in real estate below.
Return on Investment (ROI)
This is the total return you receive from the capital invested and one of the most common types of return formulas in any investment.
Pro: Very simple to calculate
Con: Does not take into account the timing of returns
Average Annualized Return (AAR)
This piggybacks on the ROI and is helpful to quickly see an investment's long-term performance.
Pros: Simple way to see returns over a given time period Cons: Does not take into account the timing of returns
Internal Rate of Return (IRR)
The technical definition is the “discount rate that makes the net present value of an investment zero”. In more simple terms, it is the expected compound annual rate of return that will be earned on an investment. IRR incorporates the concept of time value of money (TVM), which means that it adjusts returns based on the fact that money received today is more valuable than money received in the future.
This is one of the most common returns used in real estate for the fact that the timing of returns are taken into consideration.
Pros: Takes timing into consideration when calculating returns which provides a more detailed picture of your return.
Cons: Very difficult to calculate by hand which will require trial and error to figure out or by using Excel. This also assumes you are reinvesting all capital that is returned throughout the period and receiving a similar return.
Also known as cap rate. This is used to indicate the rate of return that is expected to be generated on an investment. The cap rate simply represents the yield of a property over a one year time horizon assuming the property is purchased with cash and not leveraged. The capitalization rate indicates the property’s intrinsic, natural, and un-leveraged rate of return. There are no clear ranges for a good or bad cap rate, and they largely depend on the property and the market.
Pros: Quick and easy number to compare similar asset classes
Cons: Does not take into account leverage, time value of money, and future cash flows from property improvements.
This is similar to return on investment and is a measurement of total cash generated from the amount of capital invested.
For example, when you see 2.0x equity multiple over 5 years, this means the investment is projecting 100% return on your investment over 5 years.
Pros: Quick and easy way to see overall returns
Cons: Does not take into account time value of money
As you can see, there are several ways to calculate a return on your investment and no one-size-fits-all approach exists to help an investor see their returns. The wisest way to determine if a potential investment is a good one is by looking at a combination of returns that cover all the factors mentioned above and taking a holistic approach.
A recent unscientific poll I conducted on LinkedIn provided the following results when I asked which one return was the most comprehensive in showing returns:
While this is contradictory to what was written that there is no one-size-fits-all return, many investors look at the IRR as the most comprehensive. The reason this is preferred is because IRR takes into account the timing of the returns. If some or all of your capital is returned earlier in the investment, then your IRR will be higher. With average annualized returns or the equity multiple, the timing of the returns do not make a difference as it only takes into account the total returns.
The IRR does assume you are reinvesting the funds returned to you and earning a similar return. If you don’t reinvest the funds, then there really is no difference between the IRR and annualized return or equity multiple.
Because there is not a one-size-fits-all return that will give you all the answers, pay attention to what returns they are using when an investor or sponsor discusses returns. Many times, they are using the one that provides the highest returns. It may be the case that one looks really good, while the other returns may not. It is best to take a combination of returns of your preference to get a full picture of the investment, then choose the best investment that will help you accomplish your goals.