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Today’s Quiz:

What is my return on the following investment:

I bought my first investment property back in August 2008. I paid $63,500 for the house using my own cash. I spent the next two months rehabbing it with $34,000 of my own cash. It sat for about 5 months before I lease-optioned it for $1000/month in rent, starting May 2009. In August 2010, I refinanced and pulled out $66,320 in cash. It cost me about $2300 to do that refinance. I spent $1400 on property taxes in August 2009 and another $1200 in property taxes in August 2010. I’m expecting the tenants will be able to purchase the property for $120,000 in July 2011, and I’ll end up netting about $50,000 after all fees, commissions and loan payoff.

If you don’t know how to calculate the correct answer to that question – and as a real estate investor you SHOULD know – I highly recommend you keep reading…

Anyone who reads my BP blog posts or my blog probably knows that I’m a hard-core numbers guy. While I don’t discount “gut feel” when it comes to investing, if the numbers don’t work, it doesn’t matter how excited my gut might be. I like to examine the financial aspects of a deal before I buy, while I’m holding and then after it’s done. That way, I can mitigate the risk of financial surprises as much as possible.

Seeing as how I’m such a numbers guy, I find it very surprising when I speak to investors who don’t seem to have clue how to analyze a deal or how to determine how profitable a deal was after it’s completed. It’s not that most investors are stupid (far from it!), but many investors have never spent any real time learning the basics of analyzing investment numbers.

I’ve spent many of previous BP blog posts discussing how to analyze a deal upfront to determine if – in theory – the deal is a good one; today I want to tackle the other end of the deal and discuss how to determine whether a specific deal was profitable after all is said and done.

First, let’s clear up some common misconceptions. I’m sure most investors have heard terms like “cash-on-cash return,” “total return,” “return on investment,” etc. These are all terms that indicate in some way, shape or form how successful a particular deal is. The most common I hear people referring to is Return on Investment, or ROI. For many investors, this is the one number that summarizes the entire success or failure of a particular investment.

For those not familiar, ROI is calculated as follows:

ROI = (V1 – V0) / (V0), where V1 is the ending balance and V0 is the starting balance.

A simple scenario for using ROI to calculate an investment return would be as follows: On January 1, you put $1000 into a bank account. On the following January 1, you cash out the account for $1100. Your ROI on the investment is:

ROI = (1100 – 1000) / (1000) = .1 (or 10%)

You start with $1000 and end up with $1100 after a year for a return of 10%. Seems pretty straightforward and even the most non-mathematical among us should be able to do that type of calculation.

Now what if I give you the following scenario: On January 1, you put $1000 into a bank account. On February 1, you put another $500 in the same account. On September 1, you removed $250 from the account. And then on October 1, you removed another $250. On the following January 1, you cash out the account for $1100. Like the first example, you started with $1000 on the first day of the year, and you finished with $1100 on the first day of the following year.

So, is your return still 10%? At first glance, you might think so. In fact, using the ROI formula above, the ROI on this investment appears exactly the same as the previous investment. But, given that you had $1500 invested for several months of the investment period (from February through September), you’d think that a 10% return should have resulted in a higher ending balance. So, in actuality, your ROI is probably a good bit less.

As you can see, the ROI formula has two big limitations:

1. For any investments that involve sums of money going in and coming out through the life of the investment, ROI will pretty much ignore every in-come and out-flow other than the first and the last;
2. ROI doesn’t take into account the amount of time an investment was held. For example, let’s say in that first example, the $1100 was cashed out after 5 years instead of one – according to the ROI formula, the return is still calculated at 10%.

This is where Internal Rate of Return (IRR) comes in. IRR is the much more powerful cousin to ROI, and while also more complicated than ROI, it’s an essential tool that all serious investors need to understand. I’m not going to go into the nitty-gritty of how IRR is used (and yes, there are some downsides to using IRR that I won’t go into here), but I do want to review the basics…

First, you may hear IRR referred to by different names – on your mortgage truth-in-lending statements as annual percentage yield (APY), as the “effective interest rate” of a loan, as the discounted cash flow rate of return (DCFROR), or sometimes even as the generic rate-of-return (ROR). All of these things essentially mean the same thing, and serve to underscore how important and versatile the concept of IRR is when it comes to investing and finance.

(For the other hard-core finance geeks out there, IRR is most specifically defined as the discount rate that makes an investment’s net present value (NPV) equal to 0.)

Second, and most importantly, I want to do a quick summary of how to calculate IRR for a given investment. Unlike ROI, you can’t calculate IRR in your head. In fact, even doing it with pencil and paper is practically impossible. But, calculating IRR using Microsoft Excel (or any other financial software) is a piece of cake.

In Excel, list the monthly (or annual) dates of your investments in sequential order in one column. Next to each date (month or year), list the aggregate in-come or out-flow for that time period (in-comes are positive and out-flows are negative). Then use the XIRR function in Excel to calculate your IRR. Using the example above where we deposited $1000 into a bank account on Jan 1, deposited another $500 on Feb 1, removed $250 on Sept 1, removed another $250 on Oct 1, and then removed the remaining $1100 on following Jan 1, our Excel calculation would look as follows:

As we suspected above, our return was a good bit less than 10% (almost 25% less!), despite our ROI calculation of 10% return. As you can see, doing a quick ROI calculation in your head would left you feeling a lot better about your investment than it probably should have.

If there is enough interest, I’m happy to go into more complex uses of IRR in future posts, and am also happy to discuss some IRR nuances that sometimes affect the ability to accurately determine returns of some types of investments. In the meantime, if you’re interested in learning more about IRR and how to calculate it using Excel, there are some good online tutorials.

Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.