Is Your Capital Working? Or Are You Working?

Question

Lately I have seen a number of posts from what I consider some of our most respected posters on the board using standard procedures to calculate returns. One of the calculations that happens frequently is that someone figures a project return for a project that takes less than a year and then annualizes it. The AROI is then touted as some really big impressive number. This analysis assumes that one will immediately find a new project of equal yield and place the capital in service afterwards. This seems dubious to me.

Most of these projects are really akin to well-paid jobs. Hard money lending, flix-and-flipping, new construction, etc. can all return extraordinary amounts on invested capital. However, one needs to be careful to include their time in the analysis of the project. One also needs to be careful not to annualize figures when the capital will be idle between projects. This grossly distorts the true returns.

What portion of overall "project yields" can be attributed to this accounting of effort or time instead of an accounting of how hard the capital is working in your estimation? For those that are using their own capital and their own time how do you account for this division? Do you use fees ($/hr) for your time and yield measurements for your return on capital?

J Scott · Answer

Bryan - If I recall, you've started a thread on this exact topic at least once or twice in the past (I think I've commented on two of your threads of this nature, in fact). And, if I recall, the responses you've gotten in the past were all pretty good. With the myriad of ways to measure investment success, the unlimited number of specific investing situations (investments and investors) and the wide range of investment goals one might have, there's just no apples to apples comparison. The right measure for one person is probably not the right measure for another. For example, personally, the two things I care about are: 1. That my personal net worth is growing at a satisfactory rate so that I can reach my future financial goals; and 2. That I'm generating enough profit that the work I'm putting in is being well compensated (specifically, that my $/hour earn is over a pre-defined threshold). I have a percentage of my own capital tied up in my real estate business and don't have any outside investors. So, at the end of the year, it's easy enough for me to do a simple ROI calculation using my starting and ending balance sheets -- this gives me the information I need to evaluate #1 above. And, because I'm working in the business part-time and can track my hours, I can divide the increase in net-worth by the number of hours I put into the business to determine my hourly wage. This gives me the information I need to evaluate #2 above. Of course, my situation, goals and investment scenarios are going to be different than everyone else, so there's no reason to believe that my evaluation metrics are universally useful -- or even useful to a single other person. If you want to go into more detail about your situation, goals and investments, perhaps we can help you figure out the right metrics, but to assume that what works for others will work for you is probably a bad assumption.

Jake Kucheck · Answer

I assume you mean the relevant portion, with regard to adjusted AROI. So, in the model you don't like, you are seeing: ROI * (365/X) = AROI, with X as the number of days the capital was in use. The adjustment is very simple, just plug in (X+Y) for X, with Y being the number of days the capital was idle (in our case, available to us but waiting to be used for a trustee sale acquisition). Since the longest it ever takes us to place capital is about two weeks, Y is rarely larger than 14 or so. If you want the whole ROI calculation that goes into that... that's a bit of a different topic but I'm happy to share privately.

Jake Kucheck · Answer

Looking at AROI for individual projects is dubious, I agree. Looking at AROI for a number of projects is actually a pretty good way to measure, if you have a large enough sample size, are fairly consistent with the AROI that is produced and have zero or negligible down time between projects. AROI can also be adjusted to reflect down time, which our model does.

Mitch Kronowit · Answer

So that time I rolled through Vegas and threw a quarter into a slot machine and got two back wasn't really the 630,720,000% ROI I've been bragging about???? ;-)

Joel Block · Answer

Interesting that you bring this up. Many calculations surrounding returns are based on fancy financial mathematics and university style formulas, but those of us who are in the trenches know that it is critical to separate two entirely different realities. First there is deployed v. not deployed capital. Serious investors only care about what they get - and for that to be maximized, their funds have to be deployed. Second, there are passive and active investors. Most money made in traditional investments such as stocks, bonds, commodities, and mutual funds are always passive, so 3% ROI means 3% ROI. Real estate is one of the few investments where the capital is super-charged by the efforts of the investor. For some players, this can be great, but when evaluating the result, the investor has to remember to remove themselves from the equation to see how much the money returned. 20% returns are easy when one is working in the deal (meaning that the money didn't really return that amount by itself) but there is a very strict limit on how much an investor can make when they are contributing capital. It is not necessarily better to be active or passive - as long as the investor is aware what the basis is for making the money. Just remember that wealthy people put the money to work because they know that their personal efforts are strictly limited in the amount that can be produced.

Chris Masons · Answer

I seem to have a similar model that J Scott uses. My main concern is that my passive income is helping my networth grow on a yearly basis. Not counting appreciation and or equity but those are huge pluses as well It can get a bit confusing bc due to my passive income I am able to max out other investment vehicles from my W-2 income IE. Maxing out work 401k and maxing gout Roth IRA from W-2 income. This in itself gives my some big tax savings as well as a bigger return on my money and if it weren't for my passive income cash flow I would not be able to allocate my W-2 incoome as aggressively to reaching my financial goals. Chris

Bryan Hancock · Answer

I agree...I just wanted to get a better sense for what others are dong. This thread has dug up some more responses.

Bryan Hancock · Answer

Makes sense Jake...please do share if you don't mind. I would like to see what you guys are doing with your modeling.

Bryan Hancock · Answer

Would you mind sharing your model Jake?

Bryan Hancock · Answer

Only if you account for the time you spent driving over to the slots Mitch ;-)