2 Proven formulas to measure the success (or failure!) of your investment

If you ask any successful investor, they will tell you that knowing how to measure an investment appropriately is a vital component of their success.  If you are considering investing in real estate, you need to understand the different ways to measure the return on your money if you want to succeed!  This article will cover two proven methods used in real estate and some situations that you can utilize them.

There are many ways to analyze an investment return.  Two of the more popular methods to measure a multifamily investment’s performance or real estate, in general, are Return on Investment or ROI and Internal Rate of Return or IRR.  Both of these methods provide you, as the investor, different investment perspectives and should not be used interchangeably when evaluating an investment opportunity.  However, knowing the distinction between them is essential when assessing which investments you should and should not choose.

Let’s review each in detail and look at some of the similarities and differences.

RETURN ON INVESTMENT (ROI)

Return on Investment, or ROI, is one of the most common – and easy – ways to measure an investment.  ROI looks at how well an investment did in the past.  Simply put, it is the measurement of the gain or loss of an investment relative to its cost.

Example:

(Total gain (or loss) – Initial investment) / Initial Investment = ROI

  • Initial investment: $50,000
  • Total gain: $60,000

($60,000 – $50,000) / $50,000 = .2, or 20% ROI

In this example, you invested $50,000 and received $60,000 at the end of the investment.  You made $10,000 and received your initial investment of $50,000 back.  So, your ROI is $10,000, divided by $50,000, which is 20%.  Not too bad, right?

It is important to note that ROI must be taken into context.  For example, if the investment in the example above were for a year, then the ROI would be fantastic.  However, if it was for 10 years (20%/10 years), the ROI would be 2% a year and would not look like an excellent investment.  When considering more extended holding periods and/or varying returns, you should look to a method that has become the industry standard for estimating returns on multifamily investments.

INTERNAL RATE OF RETURN (IRR)

The Internal Rate of Return, or IRR, by definition, is the compound annual rate of return that sets the net present value of all estimated cash flows equal to zero.  If it sounds confusing, that is because it is!  Not only is the definition confusing, but the equation for determining the IRR requires the use of a calculator because of its complexity.  The good news is that we will help break it down for you…in English.

IRR is a way to calculate an investment’s return over a set period of time.  It is expressed in a percentage representing how much money you stand to make from an investment by helping you estimate your money’s future growth potential.  Where ROI looks at the past performance of an investment, IRR considers the time value of money, providing you with the annual growth of your money over a period.

IRR is one of the most precise evaluations of how an investment performed because it helps you assess the effective return rate in one annualized metric.  This metric can consider inconsistent cash flows and/or a lump sum gain from capital events (like the sale, trade, or refinance of an investment).  This is one of the main reasons IRR has become the industry standard for determining a commercial real estate investment’s value. 

Ok, now that we get an idea of what IRR is, let’s look at an example.

Let’s say you invest $200,000 in an investment property for five years and earn no return on the first year, generate $20,000 for the next three years, and then sell the property on the fifth year for a $30,000 net profit.  The IRR would be 8.505%, while the ROI for the investment would be 45%.  If you did not know that the ROI was for a five-year hold period, this might seem like an excellent investment.  However, this is why IRR can be a great way to compare investments with different cash flow structures and holding periods in determining what investments are best suited for you and your investment goals.

If you want to calculate the IRR of an investment, make sure to use one of the many free online IRR calculators as the formula is very complex and confusing.

ROI / IRR DIFFERENCES

Return on Investment

  • Good for determining short-term investment performance
  • Useful to calculate/define growth rate
  • Easy to calculate

Internal Rate of Return

  • Good for determining long-term investment performance
  • Useful for considering the time value of money (annual growth rate)
  • Difficult to calculate because it considers several factors

ROI / IRR SIMILARITIES

  • Both expressed as percentages allowing quick evaluation and comparison
  • You can use both as an evaluation of previous or estimated performance
  • Both can represent the average annual return on an investment

SUMMARY

Understanding how to measure your potential returns is crucial to picking the right investment for your particular situation.  ROI and IRR each provide you with unique perspectives of looking at the success of your investment.  Where ROI is simple to calculate, it fails to take into consideration the time value of money.  While IRR considers the time value of money, it is also relatively harder to calculate.  The key is to understand the advantages/disadvantages of each and when to use them.  Just remember, there is always more than one way to calculate an investment return, but the method that works best for you will depend on the type, term, and other factors of the investment.