General Terms
Return on Investment (ROI)
ROI is a generic term often referenced in investing. It is a percentage of how much money you’re making, and it depends on a number of variables. There is more nuance to ROI than you’d expect, so we’ll discuss some specific types of ROI.
Cash-on-Cash ROI (CoC ROI or Cash-on-Cash Yield)
CoC ROI is an extremely common metric in investing. It is essentially “bank account ROI,” meaning that if you invest $100K and see $10K of cash flow (i.e. cash returning to your original bank account) over the first year, you earned a 10% CoC ROI. It’s what most investors care about because it tells you how much cash you are receiving.
Cash-on-Cash ROI = Annual Net Cash Flow / Invested Equity
Annualized ROI
Another way that investors will compare returns is by annualized ROI, which means looking at the return on a yearly basis. If I offer you a deal where you’ll make a 90% ROI, it may sound like a great deal, but the timeframe plays a big role. What if that 90% ROI is made over the course of ten years? It’s not such a great deal now. What about over the course of ten months? Now that’s a much more solid return! The annualized ROI will either average longer term (i.e. multi-year) investments or expand short term investments to a yearly basis.
Annualized ROI = ((P + G) / P) ^ (365 / n) – 1
Where P is your initial investment or principal, G is your losses or gains in the investment, and n is the number of days invested.
Instantaneous ROI
“How much money will I make on this deal?” Well, it depends! If you want to know your ROI at the end of an investment versus at the beginning (again, without referencing how long that investment lasted), you can calculate the instantaneous ROI.
Instantaneous ROI = (P + G)/G – 1
Where P is your initial investment or principal and G is your losses or gains in the investment.
Equity Multiplier
An Equity Multiplier is another way to show instantaneous ROI, showing it not as a percentage but as a number. For example, if you invest $100K and make $75K in cash flow (plus you get your original $100K principal back), you would then have $175K in your bank account; your equity multiplier would be 1.75x. It’s the same formula as Instantaneous ROI, except you are not identifying the value as a percentage here (i.e. you’d normally multiply the previous ROI calculations by 100 to get the percentage values). Remember, it does not contain a time component, so by itself the Equity Multiplier may not give you all you need to know about an investment.
Equity Multiplier = (P + G)/G – 1
Where P is your initial investment or principal and G is your losses or gains in the investment.
Gross Rental Income (GRI)
This term refers to how much you actually collect in rental income.
Gross Yield
This term is another one used to compare properties at a basic level to weed out the bad deals quickly. It compares how much income a property can produce compared to its value. I use this method to filter a list of potential short-term rental properties to determine which I’ll analyze more deeply. I like to see a minimum of a 10% Gross Yield (i.e. If I buy a property for $500K, I want it to make at least $50K per year in gross rent).
Gross Yield = GRI/Property Price
Gross Rent Multiplier (GRM)
This calculation is essentially the opposite of Gross Yield. Where a higher number in Gross Yield is better, a lower GRM indicates a higher potential for larger returns. For example, I like to see a maximum of GRM of ten.
GRM = Property Price/GRI
Potential Gross Income (PGI or Scheduled Income)
PGI is how much a property could make if it were performing at maximum level in the market (i.e. all units being charged full market rent). It’s the pie-in-the-sky number that you shoot for in performance.
Physical Vacancy
This term tells you how much income you’re not earning due to not having tenants in your properties. It can be shown as a percentage (as a vacancy rate) or a dollar amount (as a vacancy expense). For example, if I have a ten-unit apartment complex, but one of my units is vacant, I have a 10% vacancy rate. If I could charge $1K for that unit, the vacancy expense is $1K––it’s an expense on my financial statement because it’s a missed revenue opportunity. For single-family residential (SFR) and long-term rentals (LTR), I often budget for an 8% vacancy rate, which equates to my property being vacant one month out of each year.Lorem ipsum dolor sit amet, consectetur adipiscing elit?
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Economic Vacancy
Economic Vacancy accounts for the loss to the potential income of a unit compared to market rent if you have a tenant in place. There are three main types.
Concessions
These are a special promotion given to a tenant in exchange for something else of value to you. For example, I might allow a police officer to live in my apartment complex at a discounted rate because I want their squad car present for safety. If my market rent for a unit is $1,200/month and I charge the officer only $700/month, I would have a $500 Economic Vacancy expense.
Bad Debt
This occurs when tenants are behind on rent or fees owed.
Loss to Lease
This is the difference between the market lease rate and your current tenant leases. If I have ten units leased at $900/month but the market rent has increased to $1K/month, I’m showing a Loss to Lease of $1K/month total (i.e. $100/unit).
Additional Income / Other Income
These forms of income are the additional means of making money outside of rent. Some common examples include laundry service, pet fees, or RUBS (see below).
Effective Gross Income (EGI)
When you calculate EGI, you start to see more realistic numbers in your calculations as opposed to those pie-in-the-sky numbers in the PGI. To determine the EGI, you take the PGI plus any additional income and then subtract both the inevitable physical and economic vacancies.
EGI = PGI + Additional Income – Physical Vacancy – Economic Vacancy
(Normal) Expenses
Think of Expenses as your regular monthly bills, such as management fees, utilities, basic maintenance (i.e. fixing leaking toilets, repairing HVAC units, etc.), regular contractor fees (i.e. lawn care, pest control, etc.), administrative costs, payroll, insurance, taxes, etc. These expenses do not include your debt service and CapEx (see below).
Net Operating Income (NOI)
NOI is a significant variable in the investor world, especially in commercial real estate where it’s discussed ad nauseam. If you were to buy a property with cash and not consider CapEx (see below), NOI would be your cash flow. Simply put, NOI is income minus expenses; to be more specific, NOI is your EGI minus your (Normal) Expenses.
NOI = EGI – Expenses
Debt Service
This term refers to how much you pay for any debt on the property. Usually, it’s the principal and interest owed to the bank, but it could also be money owed to a private lender, hard money lender, or another lending outlet that has a mortgage on your property. Sometimes, debt service will be interest-only payments, with the principal on the loan not being paid down for the first couple of months or years of ownership.
Capital Expenditures (CapEx)
CapEx is the cost for repairs to or replacement of substantial items on your property that are not handled on a regular basis. Some examples include roof replacements, HVAC replacements, repaving roads at a Mobile Home/RV park, large renovation projects, foundation repairs, etc. There can be a gray area as to what counts as CapEx and as Normal Expenses, but it is important to separate the two as much as possible, especially in the commercial space, because adding additional expenses will reduce your NOI, which will reduce the value of your property. There are also tax implications between categorizing something as a Normal Expense versus CapEx.
Replacement Reserves or CapEx Reserves
These terms refer to funds set aside to cover large CapEx items that you expect to happen in the future. Usually, you set aside a small amount each month. For example, if you expect the roof on a property to need replacement in ten years and estimate the cost to be $12K, you will try to save $1K/year (or $84/month) for if/when that roof needs to be replaced.
Cash Flow
In REI, you’ll often hear the phrase, “Cash flow is king.” And Cash Flow is just what it sounds like it is: the flow of cash at the end of each month or year. It is different from NOI in that it considers Debt Service, Capital Expenditures, and Replacement Reserves.
Cash Flow = NOI – Debt Service - CapEx – Replacement Reserves
Working Capital
Working Capital is simply your current assets minus current liabilities. By “current,” I mean as expected over the next twelve months. Whereas Cash Flow tells us how much cash your investment can make over time, Working Capital is a snapshot of your investment’s financial health now.
Investment Reserves
If your investment stops producing income, the amount of time before you will be out of money is determined by your Investment Reserves. Sometimes lenders will require a certain level of reserves to be set aside at closing. This calculation will vary from investor to investor, but common reserve levels are three, six, and twelve months––meaning that you have enough saved up to weather the storm for that amount of time if your EGI went to $0.
Net Present Value (NPV)
While not commonly discussed in REI, NPV is an important concept to understand. Say I have two investment opportunities. In Opportunity #1, I lend you $100K, and you pay me back $125K in one year. In the Opportunity #2, I lend you $100K, and you pay me back $125K in five years. The first opportunity will be much more exciting to me. Why? Because time affects the value of money. NPV accounts for that time-value of money.
In my examples, to decide whether or not to invest, I would need to consider how much my current cash of $100K will be worth in the future by using an assumed rate of return (also known as a discount rate). I won’t get into the actual mathematical formula for calculating NPV because it’s unnecessarily complex for this discussion, but you can search for it online if you are that curious.
Let’s say I’m confident that I can grow my current $100K at a 9% annual rate of return. In one year, under normal or expected conditions, I can expect to turn that $100K into $109K.
Opportunity #1
($125K in one year), when discounted at my 9% annual rate, results in an NPV of about +$14,600.
Opportunity #2
($125K in five years), when discounted at my 9% annual rate, results in an NPV of about –$18,700.
Basically, the NPV of +$14,600 represents the intrinsic value of investing in Opportunity #1 compared to my assumed rate of return under normal conditions where I expect a 9% growth. The NPV of –$18,700 represents the intrinsic loss of investing in Opportunity #2 compared to that assumed rate of return––in other words, I’d be better off holding onto my money and letting it grow where it is rather than investing in Opportunity #2.
Make sense? Remember, in the big picture, time always affects the value of money!
Internal Rate of Return (IRR)
IRR is a metric used more often than NPV. IRR is the rate of return at which the NPV of an investment equals zero. The usefulness of IRR is its ability to represent an investment opportunity's possible return so you can compare it with other opportunities. IRR also takes into account the time value of money––the speed at which you will get your money back––so it’s not nearly as simple as Annualized Return.
For example, let’s compare two investment opportunities.
Opportunity #1
You can invest $100K into a syndication. You can expect to earn $10K/year for five years and then get your original investment of $100K back in year five when the property is sold. Thus you can expect to have $150K total in five years.
Opportunity #2
You can invest $100K in a syndication. You can expect to earn $8K in year one, $100K in year two due to an expected cash out refinance, and $8K in years three through five. Thus you can expect to have $132K total in five years.
Which investment yields a higher return based on the time value of your money? You can answer this question by determining the IRR of each investment. (Again, I won’t go into the formula itself, but you can find it online.) The IRR of Opportunity #1 is 10.0%. The IRR of Opportunity #2 is 13.1%. The big payout in year two of Opportunity #2 is the crucial difference because the sooner you get your money back, the sooner you can reinvest it and grow it more. Thus, Opportunity #2 offers you more chances to grow your wealth when considering the time value of money.
Clear as mud? Basically, IRR is a metric commonly used to compare investment opportunities because returns aren’t always as consistent and straightforward as we’d like them to be.
C-Suite
I had to google this term when I started dealing with wealthier clients, so this will hopefully save you the effort. The C-Suite refers to the executive-level managers of a company, like CEO (Chief Executive Officer), CFO (Chief Financial Officer), CTO (Chief Technology Officer), etc. All the “chiefs” are the C-Suite.
