Return on Investment - Posted by Rick

Posted by Paul on November 15, 1998 at 21:34:26:

Trying to understand rates on a BBS is tough, which is why I only gave the simplest equity rate to calculate for investment comparison, and didn’t even go into yield rates. For the typical small residential income property, the equity rate is an adequate tool. I only use yield rates for analysis of shopping centers, multi-tenant office buildings or other properties that may have long-term tenants.

Return on Investment - Posted by Rick

Posted by Rick on November 15, 1998 at 11:33:29:

Hey folks! How do you compute your return on investment or your yield? (may seem simple to some but I was shown a couple of ways and am now confused.)

Re: Return on Investment - Posted by Paul

Posted by Paul on November 15, 1998 at 18:23:56:

There are numerous forms of rates, which can be either (1) rates to the overall property value or (2) rates to your equity investment. Next, two major categories are capitalization rates versus yield rates. Cap rates can be applied to either (1) or (2) stated above. Cap rates represent a one-year “snapshot” look at the relationship between income and value or equity. Yield rates are a “dynamic” look are the same relationship, but take into consideration more specific cash flows over time and the change in value or equity over time. There are also rates before tax and after tax. Are you even more confused now? I can give you definitions of rates commonly used for comparison, but the most important thing is that you apply them consistently and in the same manner from property to property (example - if you calculate NOI to use in a rate calculation, each property’s NOI should consistently include/exclude items like property management and/or reserves). Just be sure you are comparing apples with apples.

Pertaining to only equity rates, the primary rate is the equity cap. rate (also called the cash-on-cash or cash throw-off). It is simply the NOI minus debt service, divided by equity invested. Example: NOI=$11,000 DS=$8,000 EQUITY INVESTED=$22,000…EQUITY CAP RATE=$3,000/$22,000=13.6%. One word of caution is that everyone seems to have different terminology for different rates. The best thing to do is see the input numbers and make the calculations yourself. The word yield is most often mis-used. True yield is not calculated from the numbers of only one-year. If you want more info. on how to calculate yields, I’d be happy to talk with you some more. However, for small properties, yield calculation may be overkill.

Internal Rate of Return - Posted by John Behle

Posted by John Behle on November 15, 1998 at 15:21:14:

Your return on investment can be as simple as entering a few numbers into a financial calculator.

The formulas built into the calculator take into account the cash you have paid out, cash you receive back and the time periods.

If I invest $10,000 and get back $15,000 in three months, I would enter negative $10,000 into the PV register of the calculator. PV is for PRESENT VALUE. I would enter 3 into the N register in the calculator. N is for the time period or NUMBER OF PAYMENTS. I enter $15,000 into the FV register of the calculator. FV is for FUTURE VALUE - an amount received at a future date. Since there are no monthly payments in this case, we enter a 0 into the PMT register. PMT stands for PAYMENT.

We then solve for the %I register. In most calculators, this is just a matter of pushing the key. In some of the calculators you need to push the CPT key (compute) or the “2ND” key (also compute) and then the “%I” key. This will give you the rate of return. Some calculators will return this as an annual rate and some will return a periodic rate that must be multiplied by 12 to equal an annual rate. In this example, your yield should come back as 173.66% if the calculator is calculating based on 3 months. You can also calculate based on an annual basis, which would mean 1/4 of a year and an annual return of 200%.

This is just one basic example. The subject of rates of return and using the calculator is at least a one day course to really understand it. The CCIM CI101 course takes one full week to cover it but includes taxation and a more accurate rate of return that is called the “FMRR” or Financial Management Rate of Return.

Unfortunately most calculators do not have very easy to understand manuals when it comes to the IRR (Internal Rate of Return) calculations. There are a couple books on the subject of time value of money calculations. “Calculator Power” by Jon Richards or “Discounting as Easy as 1,2,3” by myself.

The basics are actually quite simple. Once you understand them, then the whole subject becomes clear in sort of an “A HA!” type manner for most people.

There are three types of cash flows that you discount and a simple three step process that works on any financial calculator.

Learning the time value of money and how to use a financial calculator is one of the most valuable things you can learn as a real estate investor and absolutely mandatory for a “paper” investor. There are more details on the time value of money in the “How to articles” section and in the Cash Flow Forum on this site.

Re: Return on Investment - Posted by Richard

Posted by Richard on November 15, 1998 at 19:35:52:

If he wasn’t completely confused before , he is now.