Computing ROI when offering seller financing

[Account Closed]

I am terrible at understanding ROI. In my bottom-line thinking, there's either profit or there is not. Assuming I'm using my own funds, I understnd there's ROI when I buy and sell, but how do I figure ROI when I add seller finance to the deal?

Here's one I did a few weeks ago:

Purchase price was $5K. There were costs so let's say I'm now all in at $6K. For simplicity let's say there was no hold time, since I sold it a few days after purchase. Sale price was $12K. Terms were 1K down, 6% interest for 11 months, 11 payments of $1030.25. Total time to pay off is 12 months.

What's the formula for ROI on the $6K outlay?

[Dion DePaoli]

The utility of ROI, where we take the net profit and divide into the cost basis is not really the financial analysis you want to put weight on. When linear equations are used, such as ROI, in a short amount of time such as one year, we see they answer breaks down and is very misleading.

Here is the deal broke down:

Sum of Total Payments = $12,332.74
Total Profit = $6,332.74
Return on Investment = 105.55%

Internal Rate of Return = 16.20%

The IRR for this deal is the better and proper analysis. Your IRR is 16.20%. We can confirm this also by plugging that IRR into a Net Present Value equation and we get back the $6,000 that was invested. (we can discuss the merits of NPV later)

The ROI shows us we doubled our money, which is why it is over 100%. To a factor of 1.05, however our rate of return on the cash flow is actually 16.20% not 105%. That is, each payment or periodical cash input comes in at a rate of 16.20% annually of the original investment amount.

Present Value (Loan) = $11,000
Annual Percent Rate = 6.0%

The Annual Percentage Rate couldn't exceed the coupon (Interest Rate) of the loan. The coupon is 6.0%. Since we are only calculating 11 periods for this loan, we will not see much of a impact from time, lowering the actual rate. There really is no place in this example for APR. APR is a consumer calculation not an investor calculation. The APR is likely higher than 6.0% since we did not properly include the other costs of the loan. Present Value is the present value of future payments, this would really only produce the loan amount.

Here is the second example:

Sum of Total Payments = $70,711.40
Total Profit = $37,114.40
Return on Investment = 114.28%

Internal Rate of Return = 64.53%

Loan Amount - $40,000
Rate = 7.0%
Term (m) = 84 {7 years}
Payment = $603.71

Since this example is greater in time, we can see the effects that time distorts these numbers. It is true, for the amount that was put in, $33,000, we received back 1.14 times that amount. A similar number to example 1, but this deal is better. Frankly, it should be. We are gaining interest on our money for a longer period of time, thus we should make more money. That is, loans with longer terms simply pay more interest.

That is an important point in your mind. Deal 1 has a 1.05x ROI and Deal 2 has a 1.14x ROI. So what is that ROI number really saying? It says, the total investment, whatever it is and however long it lasts, in summation will doubly you capital base plus. For each investment. And that is really all it says. In IRR we can see that Deal 2, is a better deal, in terms of return on the capital invested considering time.

In each deal we have gain in the sale itself. In deal 1 we have a gain of $6,000 which is 100%. In deal 2 we have a gain of $27,000 which is 81.82%. There is the majority of the ROI number right there. Interestingly, look at Deal 2, note we actually make proportionately more money in interest than in Deal 1. In Deal 1, we make $332.74 in interest income from the loan. $332.74 is 5.55% of our investment. In Deal 2, we make $10,711.40 in interest income, which is 32.46% of our investment.

So then, why is Deal 2 better as described by the IRR?

The answer lies in the evaluation of how the cash flow is returned back to you, which considers time. Remember in each deal, there is a down payment and then periodic cash flow from the loan. In Deal 2, we receive $20,000 as a down payment, (I place that into period 1), that is 60.0% of the total invested capital. In Deal 1, we get back 16.67%. That is a massive difference. If we consider that, investing in deal 2 should be better because after the first period, I have risk ratio which is less in deal 2. In deal 2 I am risking 40% of my capital expecting to be paid back as time goes on. In Deal 1, I am risking 84% of my capital expecting to be paid back as time goes on.

In looking at another characteristic of both deals. Notice, Deal 1 will pay the invested capital back in a total of 5 periods which is 45% of the total investment horizon (term). Deal 2 will pay the capital back in period 22 which is 26% of the total investment horizon. Which we can translate into, Deal 2 has a longer period of time of low risk investment.

Often times I see the mistake folks make, which is typical to example number 2. Where they take the ROI percent, divide by the total number of periods and then multiply by 12 to annualize the number:

114.28%/84*12 = 16.33%

That simply is not correct. That is not the proper way to raise that number to the power of 12 mathematically. The proper equation:

(1+n)^12-1=X

You also would have to understand what number to plug in for "n", which would be 4.24%, the periodic return. We are raising the period return to an annual return.

I don't want to speak for Wayne, but I think he was making a conceptual point. The Deal 1 profit amount is $6,332.74 is just over $500 per month. That is just not a bunch of money. It is still return and your profit but is the time you spend on it each period worth $500. Only you can answer that. From a return standpoint the deal would be considered good.

I think many folks suffer from the same math issues. Not fully grasping what math to use and then what the math says. It is important to understand, analysis is not simply one math equation. If we simply used ROI as the only evaluation on these two deals, they look pretty darn similar. Once we started looking at IRR, we see they are worlds apart. Once we looked for what was different the true merits of Deal 2 came to light. So, ROI was sort of like, eh, no biggie. IRR was like, heck yea and then understanding why the IRR is so different like, holy cow, that is a better deal.