All Investments Are Not Created Equal – Important Metrics
You’ll find very quickly that there are about as many types of metrics to measure the returns of an investment as there are investment opportunities available to you. It’s important to know what the metrics are telling you, and which ones measure the results you are looking for your specific situation. We’ll outline the three main metrics you should pay attention to when investing in your first or subsequent passive investing opportunities below.
Cash on Cash Return (COC)
The cash-on-cash metric is really important for the cash flow investor that is trying to replace their W-2 income in order to leave their job or for those that have already retired and need to have consistent and steady income. The COC calculation measures the annual returns for a given period which is usually one year. To understand this calculation, assume you have a $100,000 investment, and it produces $4,000 in cash flow in the first year of the investment. You're COC returns would be 4% ($4,000/$100,000).
Average Rate of Return (ARR)
The ARR is the average annual returns that is generated over the duration of the investment. It is calculated by adding up COC returns of each year and then dividing by the total number of years. Let's assume the same $100,000 investment above produces $4,000 year one, $6,000 year two, $8,000 year three and $10,000 year four. The total returns are $28,000 over four years so your average returns are 7% ($28,000/4/$100,000).
Internal Rate of Return (IRR)
The internal rate of return metric is likely the single most important metric to look at when considering the overall performance of an investment and is probably the most important metric for the growth investor that is simply trying to grow their nest egg as fast as possible. The IRR metric helps to measure not only how much returns you get from an investment but also how fast you get the returns. As they say, a dollar earned today is more important than a dollar earned tomorrow.
The calculation on this metric is a little too complicated for the purposes of this article, but the basic premise is that the sooner you get your invested dollars back, the more valuable they are to you as the investor. To show a very high-level example, the IRR on a $100,000 investment that returns $10,000 per year for 5 years is higher than an investment that returns nothing for the first 4 years and then provides a $50,000 return in year 5. By getting the $10,000 back each year, an investor can reinvest those dollars to help the total returns on those dollars increase faster over time.
Be careful that you are using the same metrics when you are comparing investments across different operators or asset classes. And more importantly, be sure you are using the right metrics for your specific investment needs. The cash flow investor will want to pay more attention to the cash-on-cash returns and the growth investor will likely want to pay more attention to the internal rate of return.