ROI is a great tool to use when comparing different investment opportunities, but it also has its limitations.
The goal of investing is to make money, so it's natural to pursue investments that offer the highest possible return. Return on investment, or ROI, is a commonly used profitability ratio that measures the amount of return, or profit, an investment generates relative to its cost. ROI is expressed as a percentage and is extremely useful in evaluating individual investments or competing for investment opportunities.
To calculate ROI, the profit (return) from an investment is divided by the cost of that investment, as shown in the following formula:
The result is then presented as a ratio or percentage.
Let's say you invest $100,000 in Property X and sell the Property X two years later for $120,000. You made a profit of $20,000; it also means that you made $10,000 per year. To calculate your annualized return on investment, you'd take your annual profit ($120,000 – $100,000 = $20,000) and divide it by your total investment cost ($100,000) to arrive at an ROI of 20%. However, ROI calculates annual return; therefore, the Cash on Cash Annualized Return on Investment is 10%.
Let’s kick it up a notch. Let’s say you invest $300,000 ($250,000 down payment plus $50,000 in fees) and bought Property Y for $1,000,000 ($750,000 financed). After three years, you sold the Property Y for $1,200,000. During your ownership, you made $50,000 NOI per year. You also paid off the loan balance which was $720,000. That means you made $150,000 of rental income for three years. In total, you made $200,000 from the selling of the Property Y. You made $150,000 from rental cash flow. You even made $30,000 in mortgage paydown for three years.
Total Profit = $150,000 + $200,000 + $30,000 = $380,000
Yearly average profit of $126,667
Annualized Cash on Cash ROI = $126,667 / $300,000 = 0.42 or 42%
ROI is a helpful tool for comparing different investment opportunities. Companies also use projected ROI to determine which projects or initiatives to pursue based on their potential profitability.
Let's say you come into some money and are trying to choose a company to invest in. If you look at your portfolio and see that Property X gave you a return on investment of 10%, but Property Y gave you an ROI of 42%, you may be more inclined to go with Company Y. In this regard, ROI is a reliable measure of how efficient investment is at generating profits.
While looking at ROI is a great way to compare investment opportunities, ROI does not factor risk into the equation, especially in situations where ROI is calculated based on projected returns and not actual returns. In other words, ROI is an excellent way to measure what you potentially have to gain from an investment, but it doesn't necessarily tell you what you have to lose.
It's generally the case that the higher the return on investment, the more risk there is involved. Stocks, for example, have historically offered a higher return on investment than bonds, but they're also assumed to be riskier. Similarly, companies with lower credit ratings typically need to provide higher interest rates when issuing bonds than those with better credit ratings to compensate their investors for taking on added risk.
When you analyze any real estate property, you must take in consideration of Class of the property. Maybe it is a money pit building, or the property is located in a war zone. There is inherent risk in these types of properties that cannot be calculated into any equation or formula. That is why we use our Rule 1 Algo to filter these problems.
