When it comes to analyzing your income property profit, what numbers should you look at? Doesn’t ROI give you everything you need to know? For a multi-year investment, ROI alone doesn’t cut it. Let’s take a look at some of the factors.
Over the course of a year an investor strives to earn interest or profit on cash they’ve invested. That money earned is referred to as Return On Investment, or ROI.
The problem is, ROI doesn’t always give you an accurate analysis of your return — especially when you hold the investment for years.
You may have planned expansion or repairs during those years — along with an infusion of more cash. You may also be collecting rent in part of a building, while another part is being remodeled.
And what if the property is a repositioned project with substantial investment in year 1 — with no cash flow the entire year? What if cash flow isn’t taken out but is instead reinvested?
So lots of factors to consider.
Once you do sell the property, all that creative financing will skew that ROI and yield a highly inaccurate number that doesn’t really represent the whole picture.
Simply stated, ROI gives you a SNAPSHOT of investment performance for one year.
Medium to long-term investments require varied ROIs for each year.
On the other hand, IRR (Internal Rate of Return) shows cumulative investment performance for the duration of multi-year investments.
Let’s take a look at an example project.
Apartment Rehab Example
Here we have an apartment rehab project with a purchase price of $4M. We put 25% down, or $1M.
The rehab costs were $200,000 but during most of that year the apartments couldn’t be rented because of the rehab. That resulted in a 1 year income of $50,000 (again, the apartment was vacant for most of the year).
Now, for years 2-5 we had a strong rental income of $300,000 per year — then sold the property for a $1M profit.
If we take that data and arrange it like this:
We get a better understanding of how things need to be calculated.
Our initial down payment and rehab costs are in parenthesis because it is money we are putting into the project.
The positive numbers for the years 1-5 indicate that we’re getting money out.
I’ve put together a simple Excel spreadsheet you can use to do all the calculations — download it here.
When we plug that data into our IRR calculator we get a multi-year internal rate of return of 17% PER YEAR.
Now if we just went with our first year ROI we’d get a discouraging 4% — and any investor we tried to pitch that to would laugh us right out of the building!
However, a multi-year IRR of 17% (the whole story), that’s something to be taken seriously. Most savvy, accredited investors, are looking for an IRR of 8-15%.
So for multi-year investment calculations we need to look at IRR to more accurately reveal our return.