Understanding ROI for Short-term Real Estate Projects
Return on investment is a common performance metric used to evaluate the profitability, or efficiency, of an investment. There are many measures of return or metrics that relate to some form of “return”, including capitalization rate, cash on cash returns, IRR, etc.
For the remainder of this article, when we use the term ROI, we are referring to a common use of ROI as a performance measure applied at the project-level, for investments with a relatively short-term hold period.
ROI is expressed as a percentage and is calculated as follows:
The popularity of ROI is due to its simplicity, ease of comparison across investments, and lack of variation across property types and professionals. As you’ll learn, there are also limitations, which is why it’s often combined with other forms of understanding return as part of a comprehensive analysis.
Breaking Down Return on Investment
There are two components in the formula for ROI: profit and investment. Investment consists of total out-of-pocket costs, and profit is determined by subtracting costs from net sale proceeds. If a project includes financing, the investment will be reduced (since investment is total costs less loan proceeds), as will profit. Lower profit and higher costs due to financing are acceptable because the investment amount decreases, which increases ROI.
It’s important to note that costs associated with the sale of the property are not included as a cost. This is because it is assumed that the investor will not be paying those costs out-of-pocket, rather, they will be deductions that reduce the investor’s net sale proceeds and will be accounted for via a lower figure for capital returned.
Why Investors Look at All Cash ROI When Using Leverage
ROI can be applied to all-cash/unleveraged investments (investments that do not include debt financing) or leveraged investments (those that do include debt financing). If an investor is considering a project that will include debt, they still may want to look at an all-cash ROI. This is especially common for investors who are considering many opportunities and want a quick synopsis of profitability at the property-level, without taking the extra time to factor in possible financing options which often change and may or may not be available. In this case, once an investor narrows down their search, they will likely factor in debt to determine actual dollar profit after financing and related measures of performance.
Tip: Comparing an all-cash ROI with the effective cost of debt of prospective loans can give an investor a clear picture of the degree of positive or negative leverage.
The Power of Annualized ROI
Unlike ROI, which is based on actual figures, annualized ROI converts ROI to an extrapolated return if the investment maintained the same periodic return in the actual ROI over a twelve month period. Annualized ROI can be easily compared to investment alternatives (other real estate offerings, stocks, bonds, commodities) or annual costs of debt, which are often quoted in terms of annual return or borrowing cost.
Here’s an example of using annualized ROI to compare investment alternatives:
An investor is exposed to a consistent pipeline of single family house flipping opportunities. Half are light renovation projects that produce an all-cash ROI of 12% over a three month period. The other half are heavy renovation projects that produce an all-cash ROI of 18% over a six month period. The investor wants to choose one strategy (light vs. heavy renovations) and stick to it. By converting both project types into an annualized all-cash ROI, they can see that light projects produce an annualized all-cash ROI of 48%, while heavy projects only produce 36%, making the decision easy.
Now let’s take a look at an example of comparing an annualized ROI to the cost of debt:
An investor can consistently find deals that produce an 18% all-cash ROI in a 6 month period. The investor has only one option for financing the projects—a lender who will loan the investor money at an interest rate of 18% per year. With no other lending options, the lender can do one of two things: 1. take the lender’s money and do the deals, 2. do nothing. After annualizing the 12% ROI, the investor sees that the annualized all-cash ROI is 36%, which means he can borrow at 20% and still be in a position of significant positive leverage and profitability after considering his cost of debt.
Tip: Many active investors who focus on short-term projects will have a minimum all-cash annualized ROI threshold, for example: 45%. They use this metric as a first-pass benchmark to see if an opportunity is worth spending more time on. When considering any project, they will use estimates of total costs, profit and hold period to produce an annualized all-cash ROI to be compared against their benchmark. If the ROI for a project is higher than their benchmark, they proceed with further analysis or purchasing the property. If it’s lower than their benchmark, they pass.
The Velocity of Money Principle Behind Annualized ROI
Annualized ROI also provides an eye-opening indication of the returns identical projects would produce over one year, if they were done back to back by taking in not only the profitability but the time each project takes. This principle is called the velocity of money, which is the amount and rate at which money is moved from one transaction/project to the next. In other words, it shows how quickly some amount of money can be harvested from an investment and re-deployed into another.
For example: If Project Type A produces a $100 profit but it takes four times as long as a Project Type B, which produces a $50 profit, then comparing the annualized ROI of both would show Project Type B producing 2X the annualized ROI of the Project Type A. The velocity of money for both projects is behind the annualized ROI—Project Type B has a higher velocity of money.
Limitations of ROI
The most important limitation of ROI is that it does not factor in time. In a thorough analysis, it is common to account for the amount of cash flows and the timing of impacts to cash flow over a given hold period. This can include the timing of cash outlays, the timing of cash returned (from operating income or net sale proceeds), and the amounts. Once these figures are accounted for, which is often done using a cash flow analysis, measures of performance that incorporate the time value of money principle are applied.
Investors often opt for models that focus more on profit and ROI, instead of detailed cash flows, for short-term projects where income from tenants is very low or not applicable, such as house flipping or ground-up development. With these projects, time value of money has a much lower impact on results when compared to projects that span several years or more.