Last week, I got multiple K1s for my passive investments. Nothing compares to having positive cash flows on one hand, and large losses on tax forms on the other hand. Indeed, favorable tax treatment is one of the main reasons why people invest in real estate. It doesn’t matter how much you make, but how much you can keep.
This week, we are going to talk about another frequently asked question: there are so many different ways to calculate returns, what are their pros and cons? How to compare returns of completely different projects? Here are the three ways:
Return on Investment (ROI)
Average Annualized Return (AAR)
Internal Rate on Return (IRR)
Number 1. Return on investment (ROI)
The first simple metric is called return on investment (ROI). It’s calculated as follows:
ROI = your profit (or loss)/ investment amount
Easy to understand
Does not take into account the time value of the money. Table 1 shows two investments making the same total profits in 5 years, therefore the ROIs are the same. But which one you will pick? Of course the second one, because you get the profits sooner and you can reinvest those profits.
It’s even more misleading when you compare two investments with different investment horizons. Table 2 shows two investments, one makes $20,000 total profit in five years, while the other makes $22,000 total profit in 7 years. ROI tells you the second investment gives you higher return, but it’s not worth it to wait for another two years to get additional $2,000 profit.
Number 2. Average annualized return (AAR)
Average annualized return is the arithmetic mean of annual returns. It has the same drawback of ROI, it does not take into account of time value. Table 3 shows the two investments have the same AAR, yet, the value of investment 2 is higher at the end of year 5, due to compounding effect.
Number 3. Internal rate of return (IRR)
We just mentioned that all the money has time value. IRR is the rate of return of your investment to match the present value of the future cash flows and the initial cash investment for the beginning period.
It’s calculated as follows:
CF stands for cash flow for each year. When you discount all the future cash flows using IRR, it should match your initial investment CFo.
It takes into account the time value of the money: it also assumes that your portfolio grows at the same IRR every year. IRR provide an apple-to-apple comparison between completely different investments, even with different investment horizons, as long as you know all the cash flows.
Less straightforward compared to ROI.
The good news is, you don’t have to be good at math in order to calculate IRR. Excel IRR function can do all the heavy lifting for you.
You can see in table 4, IRR tells a completely different story than (cumulative) ROI. It verifies our intuition that it’s not worth it to wait for two more years just to get additional $2,000 profit.
Lastly, I often get asked the following question: in each of the future inbound cash flow, how much is return of capital (getting my principle back)? How much is return on capital (making a profit)? My personal view is, it doesn’t really matter. Why?
The distinction between principle and profit within the same inbound cash flow is arbitrary. If I give you 120 $100 bill every year, I bet you can’t tell which $100 bill is principle, which $100 is profit.
The distinction between principle and profit matters only when you calculate returns: the portion deemed to be return of capital should be used to reduce the denominator, while the portion deemed to be return on capital should be used to increase the numerator.
IRR doesn’t care how you cut your future cash flows into return on capital and return of capital. As long as you provide all the cash flows, it gives you one answer. You can then use it to compare different investment opportunities.
I hope by now you understand the pros and cons of different return metric. The key take-away is, use IRR to do apple-to-apple comparison among different investments, regardless its asset class and investment horizons etc.
For those of you who missed last investment opportunity due to the compressed timeline, we plan to have another tranche coming up in early April. Please keep an eye on our email for webinar registration. Thank you all for asking questions, we will include them in the new webinar. See you soon!
Invest with Confidence
Sharpe Investor Group
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