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?

[Wayne Brooks]

Others will define ROI as different than yield. I do it as yield, just like you were a lender.

All in equals $6,000, less $1,000 down(no hold time), so All In $5,000

PV = $ 5,000

Term= 11 months

PMT= $1,030.25

Interest Rate= Calculate

(Or, $6,000 PV, 12 payments)

Sorry, don't have a financial calculator handy, I still like the HP 12C, but from a loan Yield point of view, it looks a little over 120% APR.

[Account Closed]

I see why I'm confused. 120% sounds better than it is. Lending at 6% for 11 months isn't anything to write home about it. It's the mark-up on the "sale", not the 6% interest for 11 months, that makes the yield so high, right?

[Wayne Brooks]

Yep, I guess that's why the Lonnie deals were so popular. The money is in the spread, not the interest. Of course if it was cash, you'd be @100% in one month, which annualized would be 1300 gazillion per cent APR.

[Wayne Brooks]

Forgot to mention the obvious;

This is such a small amount of money, it's really a Return On Your Time (ROYT, a new term) not your money.

[Paul Sorgi]

Regardless how you calculate it or what yo call it congrats on such a good deal!

[Account Closed]

Originally posted by Wayne Brooks:

Forgot to mention the obvious;
This is such a small amount of money, it's really a Return On Your Time (ROYT, a new term) not your money.

But why is it not a return on my money? If use $6K of my own funds and turn it into $12K in 11 months, why isn't that ROI? Is it only ROI if I turn $100K into $200K?

The deal took me 6 hours total of phone, paperwork and mailing time. How do you calculate ROYT?

Let's do another. I bought a house for $30K a few weeks back. With costs to buy and closing costs to re-sell I'm all in at $33K. I'm getting some offers at asking if I'll carry paper. Here's one offer:

Buyer's purchase price is $60K. Buyer's down payment is $20K. Carry back $40K. Terms of the note are 84 months, 7% interest. Putting my time aside, what's the return on my $33K?

As you can probably tell, I do the deals because I can easily see the profit. But I've got to learn to do the math! Thanks for your help.

[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.

[Wayne Brooks]

Okay Dion, there you go confusing us with real financial math and industry practices again! I know your numbers are absolutely correct, I've just always liked an annual return look better.

As you said, ROI is a total return on investment, with no regard for the time to receive it. I'd rather be able to get 105% in one year, as opposed to 121% over 7 years. I know this where the IRR gets added to determine annual yield, but this is one of those perfect examples as why the IRR can be distorted, deceiving. One thing I took away from a CCIM course 30 years ago is that whatever rate you get for the IRR automatically assumes that the periodic cash flows were invested at that same rate for the life of the investment. Substantial early lump sum cash flows distort this whole equation, as in this example the IRR calculation is calculated upon the ability to reinvest the initial $20,0000 down payment at the same 64% for the entire 7 year life of the investment, which is not realistic. This is where the FMRR came in where you would use a current reasonable rate (5-8% ?) to carry the yearly cash flows forward for the life of the investment, then calculate a return based on that calculated FV. I could be saying this wrong, as it's stretching my brain to go back this far.

K. Marie, I know you're pragmatic enough to consider your time invested, as well as the return on the investment. I've just seen some rehab guys, doing all the fix up labor themselves, pointing out that they doubled their $15-20k cash investment in 5-6 months, with no consideration for their 150-200 hours invested.

[Dion DePaoli]

Wayne you bring to light other issues with all calculations. Not all users/investor have the same goals. Couple this with the issues of IRR and ROI and we have to put weight on, evaluation is not a single calculation, it is an array of contemplation and calculation.

IRR does have its limitations. That said, I am not in the camp from your class of having issues with reinvested capital. IMO, it is an academic conversation which can be put to rest by the real world. That said, the issue with IRR, which is defined as, the discount rate used that makes the net present value of all cash flows from a equal to zero. Sounds clear enough. However there are math situations where the formula can actually produce more than one answer. Typically when the signs (positive/negative) of the cash flow change per period. If the cash flow stays single signed, which is usually positive the whole term, then the IRR will only produce one result. Lump sum receipts or lack thereof, so long as the sign stays positive, do not produce multiple NPV results. It is really the sign change from positive to negative and then back.

In your point, the idea would be that the $20k in down payment recieved back in period 1 somehow needs to have its own investment rate. That doesn't change the result of the calculation of Deal 2, it is a contemplation of a bi-product of Deal 2. This stems from smaller cash flows not being able to be reinvested at nominal market rates. Using these two examples, you could simply do Deal 2 first and then Deal 1 with the proceeds of period 1 in Deal 2. Then the mind gap comes in, do we calculate Deal 1 on its own merit or inside of Deal 2?

“The rule is, jam tomorrow and jam yesterday-but never jam today
It must come some time to jam today, Alice objected
No it can't said the Queen It's jam every other day. Today isn't any other day, you know” - Alice in Wonderland

What I am saying is, I don't need to reinvest the $20k at 64% to hit my 64%. I am hitting my 64%, which delivers back to me the $20k.

What FMRR, Financial Management Rate of Return, tells us to manage the cash. The formula discounts the negative cash flows at the safe rate bring them back to prior period and the positive cash forward at the reinvestment rate. I generally don't use this method. This comes into play from a owner standpoint where there might be some large capital expenditure in the future causing negative cash flow. Well my FMRR style is simply, don't take the hit in one period, but I don't discount outlays. Accrue the payment out over time, for a nicer even cash flow.

This practice gets you in the church. Most of the BP folks are not going to need to break out FMRR or MIRR to evaluate a deal. Their cash flow is much simpler than that and they can use IRR, NPV or XIRR and come out just fine.

I think the best point you make though is, you would rather have a short term nominal return opposed to a long term high return investment. There is no way to measure investor desire, it simply must be stated. And, as I said, evaluation of any investment is not a single calculation or contemplation but we do want to make sure as a matter of practice we consistently apply the core of the same analysis so we compare similar attributes at their core to aide us in our decisions.

[Account Closed]

Thanks for your replies Dion. I was researching ROI yesterday and read about IRR yesterday. It was the first time I'd ever heard the term. Lots to digest. I'm looking to be able to understand ROI better so as to not end up like so many of my friends with investments. They couldn't tell you real cash flow or ROI to save their lives, but they are so sure they have a great investment.

[Pat L.]

Originally posted by K. Marie Poe:

Thanks for your replies Dion. I was researching ROI yesterday and read about IRR yesterday. It was the first time I'd ever heard the term. Lots to digest. I'm looking to be able to understand ROI better so as to not end up like so many of my friends with investments. They couldn't tell you real cash flow or ROI to save their lives, but they are so sure they have a great investment.

Congrats on your deals!!!

Having done exactly this for 30 years & with what you are currently achieving, by the time you understand ROI etc (as well as my old Finance Prof.), you will wake up one day with a NET worth well into 7 figures!!!

[J Scott]

Originally posted by Dion DePaoli:
>>What I am saying is, I don't need to reinvest the $20k at 64% to hit my 64%.

>>I am hitting my 64%, which delivers back to me the $20k.

Great analysis by Dion, though I disagree with this one statement. IRR implicitly assumes that all working capital thrown off by the investment will continue to generate returns equal to the IRR.

So, in this example, getting the 64% IRR assumes that the $20K down payment (and subsequent payments) are reinvested at a 64% IRR.

K. Marie - Here is a basic IRR primer that I put together a couple years ago on the blog:

[url]http://www.biggerpockets.com/renewsblog/2010/09/02/introduction-to-internal-rate-of-return-irr/[/url]

[Account Closed]

K. Marie, I know you're pragmatic enough to consider your time invested, as well as the return on the investment. I've just seen some rehab guys, doing all the fix up labor themselves, pointing out that they doubled their $15-20k cash investment in 5-6 months, with no consideration for their 150-200 hours invested.

I'm pragmatic for sure. But I want to understand the numbers and how they apply to deal returns, so I'm not guessing or hoping. This goes for time investment as well.

So, in my deal #1: True, $6K return on $6K in 12 months is only $500/mo. Since I spent only a few hours buying and selling the deal, I'd say $500/mo is ok. I know landlords getting a lot less for more hours and liability. The trouble with note deals is that you have to keep generating them. Just like re-hab or re-sale deals. Haven't figure out real passive income yet. :)

[Dion DePaoli]

@Tiffany H. that is borderline solicitation and those types of post are supposed to be in the marketplace. The videos in that link do nothing to promote and understanding of math behind the formulas only how to use the calculator application. You seem nice and I am not an admin just giving you a heads up that these posts from you have been popping up in similiar threads which is not the right place.

[Dion DePaoli]

J Scott, that is an academic debate, do you agree to that idea or do you use MIRR instead?

Then have read on this white paper: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1982828

[Dion DePaoli]

K. Marie Poe you are not alone that is for sure. I am a big fan of suggesting investors use Excel for their analysis. When we cover loan performance with investors the excel sheet provides a nice open area to put in all assumptions, calculations and period information. So you can build a nice picture of what is happening in the investment. Albeit, sometimes I use excel like a chalkboard and I forget what number I tagged to what cell. If you take your time and setup the page with proper labels and cell references, you really only have to do this once. You then can simply copy the sheet each time you do a new project. This will help you reproduce your analysis so you can make adjustments and see their impacts but keep the same relative analysis metrics.

As you make a uniform analysis, you will start to see the patterns and will be able to even respond to them in real life. Maybe not exact, but certainly with a couple deviations.

[J Scott]

Originally posted by Dion DePaoli:

J Scott, that is an academic debate, do you agree to that idea or do you use MIRR instead?
Then have read on this white paper: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1982828

Certainly an academic debate, but in certain specific situations (like multi-year projects where the cash thrown off isn't reinvested), it *could* make a big difference. That said, for most serial investors (those who tend to reinvest their capital ongoing), I agree the distinction isn't very significant. As you pointed out, my bringing it up was more academic than pragmatic.

I don't use MIRR...in fact, until you just mentioned it, I'd never even heard of it! So thanks for that!

[Bryan Hancock]

This topic could drag on endlessly. IRR is useful in many circumstances, but for short projects small movements in cash flow timings can greatly distort the results. Assuming interim cash flows will be reinvested at the project's rate is also quite silly and is a pretty big flaw. MIRR helps out a lot here, but I seldom see this used in anything presented because external-facing analysis would have to select a reinvestment rate which is unique to each investor. For Marie's purposes this would not be an issue.

Fundamentally I think that most people misuse metrics because they annualize them when the assumptions about how the money will work are dissimilar from project to project.

If you start to bring in calculating a return on your time you'd need to impute the time spent on BP, the time spent reading about real estate, etc. Where do you draw the line? That is quite the slippery slope. Using a simple dollar return on hours spent may be a superior analysis tool if time is the dominant factor in your decision set for new projects.

Another thing to consider is that some projects can and should be disqualified because they either return too few dollars relative to the amount of effort you'd need to spend on them or the beginning negative cash flows are large, which puts a lot of value at risk relative to the upside later in the project.

[Account Closed]

Wow. This thread didn't make me feel smarter, that's for sure. But thanks to all who posted for trying to help! I don't lack confidence in my ability to profit on a deal. I just thought I needed to get a little more education on ROI, since I am weak when it comes to that kind of math. You all have so much vocabulary that is totally foreign to me. The world of investment returns is like another planet.

[Account Closed]

@Account Closed : For what it's worth, I find the HP 10bii calculator manual a great place to learn these calculations, it has diagrams so you can visualize cash flows, shows exactly what buttons to push and even has an example of a wrap mortgage: HP 10bii Calculator Manual.