ROI - Does loan paydown lower returns?

Question

Cash on Cash ROI seems to be a popular metric but to me it seems deceptive. It appears to give you a temporary boost based on finding good financing. However as the loan is paid off your return becomes lower and lower approaching the cap rate.

For example if your cap rate is 7%, and you find financing at 5% you get a "boost" (maybe your CoCROI lends somewhere around 9%). You're basically making 2% on the money you borrowed (the money is earning 7%, but you are only paying 5% for it). However as you pay down the loan that starts to disappear. So your CoCROI starts shrinking with the very first mortgage payment and levels out at the cap rate.

Therefore using CoCROI will give you a higher return than you will eventually end up collecting.

It seems to make more sense to evaluate a property based on Cap Rate and treat financing separately. If you can make a little extra of the financing thats great, but it doesn't make sense to me to include it in the valuation a property. I'd treat it as a separate issue.

Consequently, paying down the loan lowers your return.... am I missing something?

Mike Dymski · Answer

CoCROI is a good pre-acquisition metric and, yes, we need to flip to ROE post-acquisition.  What we paid for a property is completely irrelevant after the closing day....what matters is the current equity and the forecasted future returns relative to alternatives.

Many investors use forecasted IRR and they frequently subject their EXISTING properties to their ACQUISITION criteria.  How we allocate our personal capital (including equity in existing properties) is an important decision.

Lesley Resnick · Answer

I am skeptical of most metrics they can be manipulated.

COC falls apart post acquisition.  If I can buy for no money down COC is infinite.

ROE falls apart if I add or remove equity from the deal.  For argument sake, a HELOC type transaction taking 100% of the equity out.  Very little equity producing a higher return then prior to the HELOC.  Assuming the equity was reinvested, where does the return get accounted for?  Assume the equity was not reinvested just spent?  The other concern I have with metrics is the estimated hold backs, repair costs, CapEX improvements, turn over, etc.  If I zero them out or max them, it adjusts the my expenses and the metric.

Depreciation/tax and principle pay down are not in the equations.  It is further complicated by repair vs depreciation.  Replace a roof and you will most-likely have zero profit for the year in actual dollars.  However, on paper you have to depreciate it based on the 27.5 years, so your metric still looks good, but you took money out of your pocket to cover the cost.

In my opinion, the only 2 "real" metrics, since are not easily manipulated are: gross rent multiplier at the time of acquisition and cashflow including principal pay down.

The metrics are important, but they should be taken with a grain of salt.  Taken alone any one of them can be misleading.  To get an accurate picture, you need several of them to determine actual performance of the property.  Further to decide if you should continue to own it?

Immanuel Sibero · Answer

@Samuel Cieszynski

This is why they invented the IRR. All the performance metrics you mentioned (i.e. CoC, ROI, Cap rate, etc.) are snapshot metrics. They are calculated EACH YEAR, so they fluctuate EACH YEAR depending on how you manage the investment (i.e. value adding, incurring capex for higher revenue, leveraging return with financing, etc). IRR is a metric that smooths out the return on your investment as a whole throughout your holding period, not just year by year measure of return.

To answer your question - does paying down the loan lowers your return?. I suggest you calculate IRR of the investment in two scenarios with all other variables held constant except loan paydown (i.e. the variable you're interested in). First scenario is to calculate the IRR assuming periodic loan paydown/amortization until you exit/sell the investment, and second scenario is to calculate the IRR assuming no loan paydown/amortization until you exit/sell the investment.

This will tell you how periodic loan paydown or lack thereof impact your IRR (i.e. your return). My guess is it depends on the AMOUNT and TIMING of cash flow coming back to you during your holding period, which is what IRR measures. The amount and timing of cash flow back to you depends on what you're doing with the property and how you manage it. So it is faulty to say that loan paydown always lowers your return... little or no correlation there.

Cheers... Immanuel

Samuel Cieszynski · Answer

The numbers I used are solely for illustrative purposes.

The point I am trying to make is that leverage can increase your returns but as you pay back principal you're leverage decreases. Since CoCROI is calculated at the very beginning when leverage is at a maximum it gives you inflated results. By the time you pay back your loan you will only be earning the equivalent of a Cap Rate, since your no longer leveraged.

Cash flow, appreciation and loan pay down seem to be touted as positives. I agree with cash flow and appreciation but loan pay down seems to me to lower returns as it literally means you are deleveraging.

Joe Villeneuve · Answer

Faulty logic.  You're getting your dollars lost in %'s.  Re-do your analysis with dollars instead of percentages and then come up with a conclusion.

First, if you are only getting 10% CoCR, I hope you are paying cash for the property.  If you are leveraging the property, and the cash "in" is the DP (20%), then a property with only a 10% CoCR is a terrible deal.

Since the CoCR is based on CASH, and most likely the income side is the cash flow, that cash flow should be the same for the next few years.  So, if this example was a good deal, you should be getting at least 50% CoCR.  That means in two years you would be made whole...and the cashflow is all pure profit.

CoCR is a great way to measure a good deal.  It also tells us what a bad one is.

Dan Bryskin · Answer

@Samuel Cieszynski, ROI vs ROE, second being return on equity. Here is an oversimplified example. Say you purchased a house for 100k, market value is 110k, say you your total investment is 5k and it generates 5k per year. Your ROI is 100%, your ROE is 50%. 10 years down the road, house is worth 300k, generates 10k. Your ROI is 200% but your ROE is 5%. Perhaps it is time to sell :)

ROI - Does loan paydown lower returns?

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