How do you calculate annualized return with refinance?

[Rob Beardsley]

Normally calculating annualized returns is very simple: sum all of the profits and divide by principal and by holding period. However, when there is a refinance event in the model, the cash flows are much lower because the debt service is higher. Furthermore, the return of capital can't (shouldn't) be reflected in the profits since it is a payback of principal and not truly profits. 

How do you go about accurately generating an annualized return % in this situation (I understand IRR is the superior calculation but investors like to know metrics such as equity multiple, annualized return, and IRR)?

Thanks!!

[Brian Burke]

@Rob Beardsley I think this just comes down to using the right yardstick for the right situation. 

Using a simple annualized return calculation is an easy way to measure a simple $/in and $/out type of investment, but it fails when the cash flows get more complicated than that. 

So for your example there are basically two ways to measure it. One is cash-on-cash. Here you divide the dollars distributed in a given year by the dollars committed during that year (or month, week or whatever). So let's say that $1MM was invested and the first year $50K was distributed, you have a 5% cash-on-cash that year. Then there was a cash-out refinance at the beginning of year 2 and $400K was distributed from refinance proceeds, leaving $600K committed. And in year 2 there was $40K distributed from income. The cash-on cash for that year was 6.67% ($40K/$600K). And so on. Now you have the CoC return for each year, and you can also average the CoC by adding up all of the percentages for each year and dividing by the number of years.

Then there is IRR. Use Excel's IRR function to calculate this by showing the investment contribution as a negative number in the first column, then the cash flow from operations, refinances, and sales proceeds (added together) each year in each adjacent column. IRR gives the benefit of showing a return that accounts for cash outflows, inflows, and the timing of each.