I-A-Q #23: Mastering the Language of Wealth: Decoding ROI for Success in Real Estate Investment
Happy Monday!
Here is an Idea, an Action, and a Question to consider this week.
Idea
Agents, if your goal is to work with investors—a highly recommended strategy given its potential to lead you towards substantial wealth—there's a prerequisite. You need to become fluent in the language that investors use.
The foundation of this language is built around a key acronym: ROI, which stands for Return on Investment. It's a common starting point for investment discussions and concluding considerations. Mastering the concept of ROI is critical to effectively communicating with investors.
Now, I know some of you are muttering, "Come on, Roar, we're not rookies here!" But hang on to that delete button and save the “Captain Obvious” nicknames for a moment. It's time for us to dive deep into the realm of ROI mathematics, because there's a lot more beneath the surface than you might think.
Decoding the ROI Alphabet
The term ROI, thrown around a lot in investment circles, is the ratio of your net profit to your investment cost. However, the devil lies in the details, and there are various types of ROI to familiarize yourself with:
Instantaneous ROI: Ever asked, "How much will I earn on this deal?" Instantaneous ROI provides the answer, representing the ROI at the conclusion of an investment. This form of ROI doesn’t consider the duration of the investment, which may be an important factor in decision making.
Annualized ROI: This is a critical tool investors use to compare returns on a yearly basis. A 90% Instantaneous ROI sounds fantastic on the surface, but the timeframe significantly impacts its attractiveness. A 90% ROI over ten years versus ten months presents very different scenarios. Annualized ROI is a practical way to normalize and compare ROIs over different periods.
Cash-on-cash ROI (CoC ROI or Cash-on Cash Yield): It's one of the more popular ROI variants, often referred to as "bank account ROI." If you invest $100K and receive $10K in cash flow within the first year, you've earned a 10% CoC ROI. Most investors highly value this as it showcases the actual cash coming back to your pocket, even before the investment has gone full cycle.
Internal Rate of Return (IRR): IRR is typically a favorite among investors as it enables a fair comparison between investment opportunities by considering the time value of money. An investment's IRR is the rate of return at which the Net Present Value (NPV) of that investment equals zero—Don’t worry, we won’t get into the weeds of NPV calculations. To illustrate this concept, let’s just look at 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. 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.
