Potential Investment Efficiency Analysis

4 Replies

I'm working on a project for my master's degree in applied math; in particular, it involves being able to consider multiple factors at once to rank potential investments for which one yields the most efficient return on investment.

The method analyzes inputs and outputs for which property most efficiently maximizes outputs, given its particular inputs.

Inputs I'm using right now: Down Payment Amount, Rehab Costs, and Mortgage Amount.

Outputs I'm using right now: Monthly Cash Flow, Cash-on-Cash Return, Cap Rate, and Initial Equity.

For inputs, I figured down payment is a given, and I decided to keep rehab costs as its own category (rather than lumping it in with down payment as a total initial cash investment) because a higher rehab cost will usually have more time and effort that go along with it. I've thought about adding an input for # of units, figuring that a 2-, 3-, or 4-unit (or more) property will generally require more landlord effort than a SFH. I've also considered adding payback period as an input (because lower is better) and debt coverage ratio as an output. I don't want to get too many inputs and outputs going on at once, so I'm trying to focus on the top factors a person would want to look at for what makes for an efficient return on investment.

I've grabbed numbers on some different properties, and it's been pretty interesting to see what different combinations of factors tend to come out on top. I also think this method could be a useful tool for an investor to analyze current investments where we could have inputs for things like monthly time commitment or general annoyance level.

Anyway, I thought I'd see what you all think. Is there anything that you would add or remove from my list of inputs and outputs to analyze?

@Tim French

I evaluate investments in general (not just real estate) by looking at their two facets - RETURN and RISK. On the one hand, to measure return the commonly used metric is IRR which takes into account all the input variables you mentioned. Risk, on the other hand, is measured by my personal assessment of variables such as time commitment, general annoyance level, market's up and down, economic cycles. For any investment, RETURN and RISK are a trade-off. A higher risk assessment of an investment would require higher return (i.e. higher IRR). This RETURN and RISK trade-off can then be applied to any investments (i.e. even dissimilar investments such as real estate vs. mutual funds, etc.) in order to determine which is expected to perform best.

To answer your question:

- None of the outputs you mentioned measures the true return of real estate. IRR does a better job. It takes into account all input variables you mentioned AND it is superior to CoC, Cap Rate, etc.

- There are quantitative variables such as NOI, debt payments, capex, cash flow, cap rate that are used to calculate RETURN, there are also qualitative variables such as location, demographics, local economic conditions that are used to assess RISK.

Cheers... Immanuel

@Immanuel Sibero

Thanks for your thoughts. I'm familiar with IRR, and I could see it having a place as an output in my analysis.

My main goal is to capture the most commonly used metrics -- and based on the people I've talked to, books I've read, podcasts I've listened to, and blogs I've read, the most commonly used ones seem to be cash flow, CoC Return, and Cap Rate -- and allow a person to compare many properties using all of these metrics simultaneously without any a priori assumptions about which ones carry more weight than others. But although I don't hear it mentioned as frequently, IRR is still possibly the most heavily-relied-upon calculation used by investing professionals, so it might be good to include.

The other nice thing about the mathematical method I'm using is that it can easily accommodate qualitative variables by assigning them a points system (e.g., local economic conditions ranked 1 to 5), which then allows them to be included as part of the analysis alongside the quantitative variables. This works because the method is dimensionless (and, as I mentioned earlier, does not rely on any a priori assumptions about weight factors or scales of values).

Thanks again for chiming in.

@Tim French

"My main goal is to capture the most commonly used metrics..."

Ahh... I see. Your first post suggests that you're looking for .. "which one yields the most efficient return on investment."
It just so happens that on BP the most commonly used metrics are not necessarily the most efficient measure of return on investment. A property with higher CoC may have lower IRR than another property. Given the same level of risks, I would choose to invest in the other property with lower CoC and higher IRR. But YES, many investors would just look at the CoC. Worse yet... they would look at cap rate!!... which is not even a measure of return. Best of luck with your project!

Cheers... Immanuel

@Immanuel Sibero , efficiency came into it because the mathematical approach I'm using is an efficiency analysis. A person could select which variables they're interested in, and the mathematical calculation will identify which investment property will most efficiently produce what output variables the investor is interested in.

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