BiggerPockets

In talking to people and reading various posts online, I see a lot of confusion and varying opinions on ROI vs. ROE vs. IRR vs. Cash on Cash. For example, some people think that in the first year when you purchase the property, ROE (return on equity) and Cash on Cash are the same. The reasoning goes that your initial equity in the property before you see any appreciation or debt amortization will be equivalent to your cash investment, i.e. downpayment. While this can be close, at times, it almost never will be exactly the same. I can think of 2 reasons:

1) Not all of your cash investment into a deal will end up being equity. Your downpayment, yes, but not your closing cost (including points, legal fees, appraisal, etc). So your equity initially will be less than your total cash investment, leading your ROE to actually be higher than your cash-on-cash return.

2) If you are buying a property below market value, your equity from day 1 will be higher than your cash investment, leading your ROE to actually be lower than your cash-on-cash. The difference even in year 1 can be quite large.

Another thing I see quiet often is people differentiating between ROI and cash-on-cash return. I've seen all sorts of explanations. My take on it is that they're basically the same. Cash-on-cash calculates your return on cash invested in to the deal. ROI (return on investment) can be calculated in many ways, but in my book it calculates the same thing - how much money am I earning on my cash invested into the deal. One deviation for ROI that I often encounter which makes sense to me is when figuring in the proceeds from resale of the property (this is when you monetize your amortization and appreciation and can calculate the $ benefit of both as a % of your original investment). I also call that calculation a "cumulative cash-on-cash return", which you can then annualize to get to a true return %.

I'd love to hear your opinions, especially differing ones.

Now, correct me if I am wrong but wouldn't you also consider the exit strategy in order to chose which calculation is important to you?

If the property is a flip then I would be concerned with ROI and net profit. But if it's a rental then ROE and cash on cash would be the primary figures even if ROI wasn't great. Correct?

Dan, you have some Enron accounting going on here.....you said your equity would be higher if you acquired a property at a discount or below market. That can not happen by definition, that thinking comes from TV gurus who lie.
The value of your property is what you paid for it, regarless of what your preceive the value to be. Now, after a year (in an new accounting period) your assets are valued at the LOWER OF COST OR MARKET, WHICH EVER IS LESS. Now, for mortgage financing, you use the current market value after one year, within a year, it's based on your cost.

As to analysis, look to the return on your cash as it may reflect a truer picture. In sub 2 or wraps, you may earn a return over the underlying loan under your contract. Such a deal requires a little weighted average analysis.

People who like to punch buttons on financial calculators like to look at ratios. From a financial aspect, most investors do not know what their real cost of capital is or what the over the hump rate is, or your opportunity costs, so you don't have a basis to compare to! It means nothing, it's just fun to do and it might bring a smile to your face, but from a financial business standpoint, meaningless. The same thing with a capitalization rate, you need to know what your cost of capital is and what alternative investment rates are before you can have an accurate rate. To keep a smile on your face, just look at how much cash you had to put into a deal and what you walk away with, much easier. Bill

Hi, I'm sorry but I will clarify for you. It's exctly like I mentioned and if anyone disagrees I urge them to seek competent financial/accounting advice. It's not someones fault if they wer misinformed or led to believe that such assumptions were or are correct, it's just a matter of misinformation. SPining the rules does not justify another rule.

Please ask any degreed accountant, ask an appraiser, and they will tell you taht there is a difference between Estmimated Market Value and Market Value, The Makret Value is never mentioned on any appraisal, it's an Estimate of Market Value.

This whole thing about look how much I made from buying that house is purley justification to pump up strategies and RE programs to sell books and materials. Ask a CPA, gosh, even an attroney should know!

What I quoted is Generally Accepted Accounting Principle requirements (GAAP).

You will see GAAP requirements in IRS regulations and who is to follow them. Business accounting in good form as required is in accordance with GAAP.

Bryan, I like your suit and obviously you read a book to know about a manager's internal rate of return, but your further description of bookkeeping leads me to believe that you may not have, let's say, an advanced knowledge of accounting. Which is not intended as a slam or to insult you, but you are way off here. The reason you can not convince a bank of this preceived equity is because it does not exist.

Look at it this way, when you fill out a 1003 for a loan you're required to put down the market value of your properties. If you call a property a 200K property when you acquired it 9 months ago for 100K and did not make improvements to it, you are over stating the assets on your application, as such would be determined by law enforcement! So, why should you use GAAP, to reflect the true nature of your financial position, so everyone can compare apples to apples, not oranges. That is exactly what Enron did, over state assets and income and it is illegal to do so

How do gurus get away with misleading people, because the claims of profiting are not in connection with any legal requirement in presenting a true picture of that financial position, it's pure BSing for marketing purposes.

The reason I am hammering away here is because there are so many new investors who are mislead into this thinking and it is not condoned nor accepted in any aspect of real estate where a true financial disclosure is required to be made. So, if one does go down that road, they need to do both "methods", one to deceive and exagerate and one for "official" reporting and business requirements.

ANother aspect, we pay tax on the profit of our sales, do you report more than your basis when you sell a property or would you say it's worth more than you sold it for? The seller that sold that property says it's worth X dollars, that's what they got for it, can the buyer say it's woth more because he thinks he got a good deal? Doesn't even make sence IMO. And, there is only one way to prove what a property is worth, that's by selling it, where the buyer and seller have basically equal knowledge, without either party having an undue advantage and conducted at arms length, where the property sold has had sufficient marketing time to the public, and where the value exchanged is in cash or it's equivelant, with good and merchantable title is given free and clear of encumbrances or liens. That probably sounds alot like the definition, widely accepted in the United States, of Market Value. So, is it possible to acquire a property below market, yes it is, if any of the conditions just mentioned were not accomplished. If you cut a deal with your brothe in law for less than what an asset is expected to sell for, your deal is not at arms length.
Maybe if you get a good deal from a bank. it's because it was not marketed suficiently (if it's trashed not many will look and the price reflects that) or perhaps the bank does not issue a Warranty Deed, so meeting the requirement for a good title may be somewhat encumbered and such is reflected in the price. So, what you paid for it is what it is worth and if it meets the tests for Market Value, that is the Market Value, any preceived value might be called My Value, but it's not Market Value. Geee, I hope that is clear, it's not just my opinion, it has a legal foundation. Bill

Good point Mark, you improved the property and that affects value! Your Estimated Market Value can sky rocket, you Market Value will not be known until it is sold ahnd your Book Value, is the cost of acquisition plus the costs of improvements, just incase you need that. So that has nothing to do with claiming you had instant equity after buying an asset. This may seemtrivial, but it does have a great impact on business, especially those claiming such equity and selling programs. I'm done. lol, Bill

Hi, OK, sounds like our formal education level is comensurate, with the exception of my experiences. No, I think I mentioned that after one year your value can be based on an appraised value, so no discrepency there either. But as you said you acquired a destressed property under unusaual (?) circumstances and therefore you deal may not conform to the definition of Market Value as used in Real Estate. If it does not, you have no proven Market Value. So, my only objection, so to speak, is that there is a claim of increasing ones assets by a preceived unproven amount, whic in my book, is deceptive. Now I'm not calling you deceptive, I'm saying that the accounting and reporting proceedure is incorrect and does not increase your net worth an hour after closing. Just too many guru books out bthere to read.

I do think you look pretty sharp in your picture, I was not being facetious. Professional, that's a good thing. Many of us look like bumbs, LOL! But that's what you can do after retirement after more than 30 years of this stuff. Good luck, Bill

Originally posted by Financexaminer

Dan, you have some Enron accounting going on here.....you said your equity would be higher if you acquired a property at a discount or below market. That can not happen by definition, that thinking comes from TV gurus who lie.
The value of your property is what you paid for it, regarless of what your preceive the value to be. Bill

Thank you!!! Finally someone who calls spade a spade!
Often people here use the term "Way below market value" or"XX% bellow market value" - Bunch of bull...
The latest property I bought was for $7,500 (No, there are no missing zeros here...you are reading it right) The property originally was listed for $19,500. I negotiated it down to that price. Did I buy a property at about 40% of the value? NO. I bought it for what it worth and I was the only one who was willing to pay that amount. If there were any higher offers, they would have been, most likey taken.

The market have spoken! I was the market!!

BTW, same goes for AVR (After Rehab Value) No one can really tell what a given property could sell after it was renovated. It simply impossible! They may be able to give a "ball park" based on comps in the area, but the definition of rehab is shady to begin with. Is it Paint, carpet and some few new appliances to sooth the eye? Or does it include , new Roof, Plumbing, Electrical system upgrade, and central HVAC?

Thanks Eddie, the contrary makes sence if you look at numbers and accept them as gospel, but they aren't. Now if you agree with me and if I made a good point, there is a little button in the top right of the post with a little plus sign on it, your computer should not blow up if you should click on that! LOL Just seems like a consperacy sometimes, LOL. Have a great day. Bill

Hey Guys - I am glad you picked up this discussion. My topic sat around lonely for about 3 months :) There have been some excellent (if differing points) above. One of the big arguments seems to be about being able to buy something "below market value". Some people have argued that "the value of your property is what you paid for it" - that may be true according to GAAP but in the real world (not the world of GURUs) but the real world of real estate investing, it's very very very possible to buy something "below market value" and, if needed, get it immediately reappraised at a higher value.

Now, the obvious way and the method which is generally more welcomed by appraisers and lending institutions is to add value to the property (pay $60, renovate for $20, revalue @ $120).

But what about a situation where you engage in an off-market transaction - meaning you are the only bidder or the only buyer aware that the property is for sale? I've done a number of transactions where someone came to me with a distressed situation and was willing to accept decidedly lower price than the value indicated by current comps. You can argue all day long about how accounting would treat this, but at the end of the day, in the real world, I bought these properties with instant equity.

On another note, great point about MIRR - it's a significantly better measure than IRR, given that IRR can really overstate the returns, especially for a high-performing project.

LOL, OK, but the reality of the world is that the rules and laws we must abide by is defined by GAAP. You can account for what ever you like in any manner that you like, say strictly from an economic skewed view, but in the end, you'll need to convert that thinking back to GAAP to re-enter the real world, like at the bank or in your tax return. The only real problem with Enron accounting is that it misleads investors.

A good example of this is the TV gurus selling programs and talking about the "profit" they made on a deal...when in fact they have no profit at closing! Plain and simple, the exagerate and mislead in order to sell their products.

All that use such tactics is doing a great disservice to those unaware of the language of business (GAAP) which is accepted world wide.

This is not just my opinion, it is the generally accepted method used to enforce laws that can send someone to jail. Really, other than selling hype and exagerations to mislead, there is no other reason to implement methods that do not conform to accepted accounting practices. Can anyone give any other example of why an estimate of value should be used to describe an unrealized profit? As RE investors move from the world of guru books and classrooms into the real world and gain experience in dealing at a higher level of professionalism in sophisticated business transactions, with all of the players that make up the industry, it will become obvious as to why we all need to be on the same page.

It is impossible to yield any consistant result from any analysis that is not consistant in it's input of data. This is where that old saying "figures lie and liars figure" proves to be so true.