ROI Question

The most valuable lesson I learned from this forum is that there is much more out there for me to learn!

Can you please read the article below and comment on the subject? Is Return on Equity a better measure?

I read this article and I think that if it is true, than once you pay off an investment, you should move to a bigger one to make more money (but a higher ROI % initially)?

I’m interested to see how the seasoned professionals think. Please comment away!

Return on investment (ROI) is a popular, useful way to evaluate an investment. Simply, it’s the return you get from an investment, divided by how much it cost you. E.g. you buy a GIC/CD for $1,000, a year later they return your $1,000 and give you $50 in interest, you’ve got a 5% (50/1000) return.

I’ve posted before on my ROI from my condo (calculated at the 6 month mark – once I’ve done my taxes I’ll post about what it looked like at the 1 year mark). Going into the future, some of my expenses will drop (my mortgage is continually decreasing, I got a break on my insurance when I renewed) and my income (rent) SHOULD go up.

Will this mean that I have a continually increasing ROI? Many people would say yes and that’s part of the reason its supposedly great to invest in real estate, but I think there’s a problem with this line of thinking. I’ve wrote about this fallacy as it relates to stocks, but I think it’s broader than that.

Say I bought a condo for $100k 10 years ago and you bought an identical condo for $150k yesterday (which is the fair market value for both of our properties). Say we both rent our condos out for $1300 / month. My ROI is 15.6% (130012/100000) while your’s is 10.4% (130012/150000). We’ll ignore all expenses just to convince everyone that real estate is a magical, perfect investment vehicle.

Now say we both come across another investment offering a ROI of 13%. Using just ROI, rationally someone might say you should sell and move your money into the new investment, while I should keep my condo. But our condos and rents are the same, so how could it make sense for one of us to pursue an alternative investment but not both of us?

The problem with this thinking is that it’s considering my condo to be worth $100,000 when its not. Its now worth $150,000. The only reasonable way to think about this is to consider the CURRENT value of the condo (look at the opportunity cost). The purchase price is totally irrelevant (except perhaps for tax calculations and whatnot).

I’ve done various calculations on my condo return. Its looks great (over 7%) when I consider the purchase price (around $130k depending on whether you factor in the cost of renos and transaction costs). It looks pretty meager (around 4%) when you look at the ROI based on the current value of the condo (similar units are selling for an ASKING price of more than $160k – I don’t know what they’re actually selling for).

I got a good price on my condo when I bought. That transaction is finished however. I can’t claim that I keep benefiting from a good purchase price into the future as long as I own it (or I can claim this, but I’m fooling myself). I could have bought it, fixed it up and sold it (flipped it) and captured this increase immediately. The decision whether to sell or rent should be based on the market value NOT on the purchase price.

I came across a mistake in the opposite direction in a real estate book I was flipping through recently. The author claimed that you should base you ROI on your equity (current value – current mortgage) which I agreed with (the current value part anyway). However, he also considered positive cash flow as the income and reached an unusual conclusion. Say you bought a $100k property for 5% down ($5k) with a $1000 / year positive cashflow. His claim was that you start with a ROI of 20% ($1000 income / $5000 equity). Fair enough. He then speculated that a year later the property value AND the income went up 10% ($110k property, $1100 / year positive cash flow). His claim was that your ROI was now 7.3% ($1100 income / $15000 equity) and you needed to sell. The problem with this is that your leverage is massively affecting your ROI in a way that certainly doesn’t smell right to me (if you could get a property for 0% down with positive cashflow his calculation would claim that’s an infinite ROI). To my mind the investment is almost exactly the same as the day you bought it: the income and the value have gone up an equivalent amount, so why sell?

Personal yield on stocks, as I wrote before, is exactly this fallacy (one of the commenters on my previous post claims this fallacy is called “mental accounting”). Your personal yield is meaningless (for anything other than making you feel good about the investment). The dividend yield, based on the current stock price, is what is meaningful if you want to evaluate the ROI of an investment going forward (again: this is ignoring the tax drag, which should be included if you’re actually thinking about selling).

Just to be clear, I don’t think ROI is a fallacy, I think it’s a very important concept. However, I often read statements that make me worry that people are misapplying it.

I love the last few lines here…

Just to be clear, I don’t think ROI is a fallacy, I think it’s a very important concept. However, I often read statements that make me worry that people are misapplying it.

In the art of Negotiations there are 2 words that totally contradict anything that you said prior to saying the word… BUT and HOWEVER.

Think about it. Go tell your wife “Honey I really love you BUT…” OR tell your Boss “I really want to go to the meeting HOWEVER!”

I tell all my employee’s to eliminate these words from your vocabulary…

SO this guy is saying that he thinks ROI is a Fallacy, and not a very important concept. Simply because of the However added right after that. And to be totally candid I agree While ROI is important the bottom line is “SCARED MONEY DON’T MAKE MONEY!!” And so many people analyze a deal to death that by the time they are ready to move on it GUESS WHAT?? Someone else already bought it.


And what is the reason for this?? Honestly FEAR! Most people are afraid to purchase a deal because what if they make a mistake?? Let me tell you that I can speak for all the old timers on here when I tell you that if you haven’t lost money on a deal at least once, you are not doing enough deals.

Here is my final thought’s if you like a deal WRITE AND OFFER LOCK IT UP! Then figure out the ROI, Cash Flow and analyze everything you wanna on the deal! HELL Hire someone to analyze the deal with you. Grab 100 of your best friends and everyone go analyze the deal at Chucky Cheese. The #1 problem is that people over analyze before they make the offer. READ YOUR CONTRACT… 99% of contracts are contingent on 3 things. Appraisal, Inspection and THE BIG ONE BUYERS APPROVAL! Meaning that if you go home and decide the deal doesn’t work for you then your out…

Never over analyze!

The problem, as you are discovering, with ROI, is that the calculation is a shapshot in time. It can go up and go down year to year. Rental property is purchased for the cash flow it generates. Rental property builds wealth slowly. A much better metric for rental property, in my opinion, is the internal rate of return calculation. The IRR uses your initial investment, your annual cash flows over several years, and present value calculations to compute a rate of return for your invested capital.

IRR will give you a better idea of how your invested capital is working over a long period of time.

ROI will impress your friends at parties.

Cashflow buys things.