How to Accurately Estimate ROI

[Brianna H.]

Am I the only one that doesn't feel like the ROI calculations are good enough? I have expenses that come up at different times of the year (taxes, insurance, etc) and then I am saving for capex, random repairs, etc.

My current strategy for determining ROI is to use the following formula:

principal paydown / initial investment

I feel like this strategy is more conservative, but still not very accurate. Does anyone else use an alternative way to calculate ROI? Maybe I should be calculating ROI on a monthly basis and taking my average? Thoughts?

[J Scott]

Originally posted by @Brianna H.:

Am I the only one that doesn't feel like the ROI calculations are good enough? I have expenses that come up at different times of the year (taxes, insurance, etc) and then I am saving for capex, random repairs, etc.

My current strategy for determining ROI is to use the following formula:

principal paydown / initial investment

I feel like this strategy is more conservative, but still not very accurate. Does anyone else use an alternative way to calculate ROI? Maybe I should be calculating ROI on a monthly basis and taking my average? Thoughts?

Couple questions/comments:

- Why are you using "prinicipal paydown/initial investment" to determine ROI? Why aren't you factoring in cashflow to the equation?

- Typically, principal paydown isn't a good measure of return simply because that return is unrealized and therefore not reinvestable or spendable.  It's like putting $100 in a savings account, getting a $2 interest payment at the end of the year and then being told, "You're not really getting access to the $2 -- to spend or reinvest -- for a couple more years."  Given the time value of money, that $2 in interest is now worth a lot less than $2.

- A common (but certainly not the only) metric used for rental properties is cash-on-cash return. This is where -- over some fixed period of time -- you total your cashflow (the amount of actual dollars you have generated from the property) and divide it by your initial investment. It doesn't include principal paydown or equity. If you pick a time period like 1-year, you can typically smooth the numbers from things like insurance and tax payments (since they are made on annual or semi-annual basis). Choosing a longer time period provides a better estimate of actual ROI, and you can normalize the number to annual ROI by dividing by the number of years used into the result (i.e., if you use two years of cashflow for your calculation, you can divide the result by 2 to get your annualized COC).

- If you want to factor in your equity/principal paydown to ROI, you can do a return on equity (ROE) analysis:

ROE = Cashflow / Equity (again, typically over standard period, like one year)

- I also like using IRR to model long-term holds -- this number is typically more relevant to what landlords are trying to accomplish (compounded returns vs simple returns and factoring in when the money goes in and comes out). Though there's some guessing with IRR, since you're modeling the entire transaction before it occurs.