3 Metrics to Evaluate Your Investment Returns
There’s more than one way to shine a penny
As an investor, wouldn’t it be great to have a single metric that could tell you if a property is a good investment or not ?
While this is a dangerously simplistic question to ask, we will attempt to answer a more precise question.
How do I evaluate the returns generated by a potential investment ?
There are several bottom-line metrics that you could use to evaluate the returns generated by your real estate investment. We will be discussing three main metrics in this article:
- The Total Return on Investment (ROI)
- The Net Present Value (NPV)
- The Internal Rate of Return (IRR)
We will go in depth on how to calculate each metric, explain the assumptions and limitations made behind each of them, and provide you with a range to benchmark your metric against.
The Total ROI
Definition
The total ROI is a single number that takes into account the price gain you expect to make from selling your investment and the total cash on cash return on investment.
In essence the Total ROI takes into account the total profit you will generate from an investment, whether it is from cash flow or from price appreciation.
Example:
You intend to purchase a property that is priced at a 1,000,000 AED in cash (closing costs included). The property is expected to produce a net operating income of 100,000 AED a year and you finally expect to sell it in 3 years for 1,200,000 AED.
Your Total ROI in this case will be calculated in the following manner:
Step 1 — Calculate your cash on cash ROI
Cash on Cash (CoC) ROI = Free Cash Flow / Equity
Cash on Cash (CoC) ROI = NOI / Purchase Price [since property is fully bought in cash]
Cash on Cash (CoC) ROI = 100,000 / 1,000,000 = 10%
Step 2 — Calculate your price gain
Price gain = (Selling Price — Purchase Price) / Purchase Price
Price gain = 1,200,000–1,000,000/1,000,000 = 20%
Step 3 — Calculate your Total ROI
Total ROI = CoC ROI x 3 years + Price gain = 10% x 3 + 20% = 50%
Things to be keep in mind
The word ‘ROI’ gets thrown out so carelessly in the market, especially by agents trying to convince you of a deal in Dubai.
At times, agents use it to only refer to the cash on cash ROI for a secondary apartment, while for an off-plan listing they might just mean the price premium that you will expect.
Make sure you know exactly what ROI your agent is referring to and more importantly ask for how long of a timeline they are speaking of, and whether they assume you will be buying the property in cash or whether you will be taking a loan to finance your purchase.
Limitations and Assumptions
It is quite the common case that when calculating the ROI, people assume that cash on cash returns are going to remain fixed and that is not too bad of an assumption if the investment timeline we are looking at is for the short-term but this completely disregards any motion in rents whether positive or negative on the long term.
The ROI could be easily over-estimated by an optimistic projection of the price gain, or an underestimation of operating expenses and thus an inflated CoC ROI.
The longer the time horizon that the total ROI is being predicted on, the less accurate the estimate.
Benchmark
A property with a total ROI greater than 20% on a one year timeline is a decent investment. This means a combination of a 10% price gain and a 10% CoC ROI from year 1 would be considered a proper deal.
The Net Present Value (NPV)
To understand the net present value, you will need to understand what I mean when I refer to : the time value of money and the opportunity cost of money.
If a friend comes up to you and says lend me an X amount of money, and i’ll give you back 100,000 dollars in a year’s time.
What is the maximum amount of money you will be willing to give ?
It will be less than a 100,000 dollars, that’s for sure.
Here’s how you should go about it:
What is the return of the best investment alternative with the same risk of lending your friend ?
Let’s say instead of lending your friend money, you could invest this money in the stock market and get a 10% return on your investment.
Then in this case, your discount rate, or in fancy words, “your minimum acceptable internal rate of return”, will be 10%.
So let’s discount your friends 100,000 dollars by 10%, the present value of this money will be 100,000 / (1+discount rate) = 100,000/(1+0.1) = 100,000/1.1 = 90,909 dollars.
In other words, 90,909 dollars will be the maximum amount of money you will be willing to invest in your friend to guarantee a 10% return.
NPV Definition
The net present value, in general terms, is calculated by discounting each year’s cash flow and then taking the sum of all the discounted cash flows.
Example
Let’s say you are actually lending your friend 80,000 dollars, but this time he will be paying you back 60,000 dollars in the first year and another 60,000 dollars in the second year.
Assuming your discount rate is still 10%, your net present value will therefore be calculated as follows
Present Value of Year 2: PV2 = 60,000/ (1+0.1)² = 60,000/ 1.21 = 49,587 dollars
Present Value of Year 1: PV1 = 60,000/ (1+0.1)¹ = 60,000/ 1.1 = 54,545 dollars
Present Value of Year 0: PV0 = -80,000/ (1+0.1)⁰ = -80,000/ 1 = -80,000 dollars
Net Present Value = PV0 + PV1 + PV2 = -80,000 + 54,545 + 49,587 = 24,132 dollars
Two things to note here:
- Your net present value is positive which indicates that, according to your discounted rate, this is a profitable investment.
- The total profit in today’s dollars is only 24,132 dollars and not exactly 40,000 dollars (-80k+60k+60k).
Limitations and Assumptions
The net present value is a very comprehensive metric, since it takes into account the opportunity cost of capital. However, keep in mind that NPV is highly sensitive to the discount rate(s) assumed by the investor.
So when assessing the NPV of an investment, in addition to checking the cash flow numbers, you will need to make sure that the assumed discount rate is a reasonable estimate of your opportunity cost.
The Internal Rate of Return (IRR)
Definition
You could think of the internal rate of return as the annual discounted ROI, or in simpler terms, it is the effective annual return on your investment.
Another way of thinking about IRR is that it is the discount rate that will make your net present value zero. In other words if your discount rate was greater than your IRR then you are losing money.
Calculating the Internal rate of return is not a simple process, instead it is a trial and error process of trying to estimate the discount rate that will result in a net present value of zero. However, most of the readily available spreadsheet software (google sheets, numbers, microsoft excel) has a built in IRR function.
You will need to start with an initial guess and try to estimate the discount rate.
Example:
In the above example where you are lending your friend 80,000 dollars and receiving back 120,000 dollars equally split over two years. Your IRR turns out to be around 32% (you can double check by calculating the NPV and making sure it is zero).
Limitations and Assumptions
The internal rate of return has a built-in limitation that it assumes the discount rate will remain fixed across time. This is not the case in real life, especially now when interest rates are poised to start increasing and thus directly affecting your opportunity cost of capital.
Benchmark
A property with an IRR greater than 15% is a decent investment. Aim to purchase a real estate investment with an IRR of around 20% or more to guarantee great returns.
A Final Word
Remember this: Numbers can always be adjusted to fit your preferences.
You will need to scrutinize your investment return metrics carefully. Check to see if you are being overly-optimistic in estimating gains, or whether you are underestimating any of your expenses.
Now it doesn’t mean that an investment with the highest returns is the best investment for you. Make sure you properly assess any potential off-plan or ready investment by looking at the whole picture, the risk involved, the projected investment timeline, and other factors before you decide whether all this aligns with your objectives.
