When someone asks you what kind of return you are getting on a particular investment or what kind of return you anticipate on a new investment you are considering, what calculation pops into your mind? For the most part, people are likely referring to or asking about how much money are you putting in your pocket every month after you pay all expenses, in other words the cash on cash return. But don’t forget to reevaluate what this return represents over the lifetime of your investment in order to optimize your returns.
• Cash on Cash Return on Investment (CoC ROI)
This is probably the most commonly discussed return of a real estate investment. CoC return is simply the pre-tax year end cash flow divided by the actual amount of equity you have invested. For example, if you purchased a property with $85,000 down and $5,000 in closing expenses and subsequently spent $15,000 in a light rehab before putting the property into service you would have $100,000 as your actual equity investment. If at the end of the year you had received a total of $10,000 from cash flow after all operational expenses and debt service were paid, your CoC return would be $10,000/$100,000 or 10%.
Note that CoC return DOES reflect the use of leverage (mortgage) in the equation as the numerator cash flow amount is net of any loan payment. However, CoC does NOT bake in any effect from taxes which can vary from person to person. CoC return also does not take into account any impact of appreciation and loan paydown over time. With appreciation and loan paydown increasing the equity held in a property over time, the CoC becomes less relevant compared to return on how much current equity you have in the property.
• Annualized Return on Investment (annualized ROI)
Annualized return is often times used in projections or a look-back period. Annualized return will take into account not only the cash flow returns received over the course of the year but also any additional return created by some sort of capital event like a sale or refinance of a property. The annualized return spreads these capital event amounts out over the lifetime of the investment reflecting an average of what your investment will potentially return or did return.
For example, say you received a 10% CoC return for 5 years ($10,000 per year on a $100,000 investment for each of 5 years = $50,000). Then say you sold the property at the end of year 5 for a gain of $100,000. Your annualized return would then be the $50,000 in cash flow returns plus the $100,000 in return from sale for a total of $150,000 over 5 years averaging out to $150,000/5 = $30,000 per year for an annualized return of $30,000/$100,000 = 30%. This might help explain where what you might think are outsized returns in some investment examples are coming from and illustrate what is quite possible in real estate.
• Return on Equity (ROE)
As alluded to above in CoC return, the ROE becomes more relevant over time compared to the CoC return as with each month/year you are increasing the amount of equity you hold in a property due to appreciation as well as any mortgage being paid down. Because of this, the cash flow you receive should be analyzed in comparison to how much equity you have in the property and not just the amount of initial funds you invested in the property to acquire it and put it into service. To do otherwise would avoid considering the impact of opportunity cost of your money (equity) and how efficiently it is working for you. What was initially $100,000 of equity initially put into the property could easily double over time to $200,000 and your return calculations are just cut in half. I’m not trying to imply that having significant equity in a property is a bad thing but did want to point out that it does alter the returns over time.
In all of this, don’t forget to also evaluate your Return on Time. This is a difficult to quantify return that gets the least amount of attention but is still important in evaluating your subjective experience of an investment as well as at times impacting your ability to scale your investments. Even if you can quantify what your time is worth, the return on time should also be considered in conjunction with how much you enjoy or dislike whatever the time-requiring activity might be. If you absolutely LOVE managing tenants in your rental property then you probably don’t care if you could make more money by handing off those tasks to a property manager to do while you spend an extra half day at your higher paying day job each month.
To be successful and efficient at scaling a real estate portfolio, you will likely have to take into consideration at some point every operational task you do and decide if you are better off doing that task yourself or outsourcing it to another person or company to take care of. In other words, always consider the value of your own time in accomplishing any individual task or over the whole lifetime of holding an investment. To reference annualized returns above, it’s a whole different ball game to look back and see you averaged a 25% annualized return over a 5 year hold on an investment that required you to personally put in 10 hours of work a week versus one you averaged the same annualized return but only put in about 10 hours a year to accomplish.
Hopefully you are making the most of both the money and time you are investing and maximizing the return on each. If you haven’t been keeping track of your returns then perhaps that’s a good place to start. If you have been keeping track maybe it’s worth evaluating on a regular basis to make sure the investment is meeting your objectives or if there are any ways you could improve your returns on time or money: Would it make sense to outsource some tasks? Is there significant equity that you could pull out and put toward another investment? Running the numbers on a property shouldn’t just be an exercise you do when picking a property to buy but rather an ongoing analysis.