Method of ROI calculation for notes

[Joshua Andrews]

I've seen several types of calculations used to determine return on a note. One is the cash on cash method, and the other most frequently used is the IRR.

I am familiar with how to calculate both on typical rental property scenarios. However a little confused with the cash on cash calculation with regards to note income.

Obviously a note is a loan or mortgage, and as such has an amortization schedule. Because part of the payment is interest and part is a return on principal, are we counting both in the cash on cash calculation?

I am under the impression that a cash on cash calculation is only based on the "profit" or in this case the interest portion of the payment.

Is this correct? If not, why and which method of calculating return do you prefer as note investors?

Interested to hear your opinions!

Josh

[Bill Gulley]

Cash on cash is a ratio of profit received from your cash invested, what you receive is principal and interest, after your return of your money is received. How useful is this? Not very much at this point.

The IRR is a measurement of an investment based on an alternative investment not taken, the capitalization rate is based on the return that you could have received from the same amount invested. Another ratio in RE that, at the small investor level, is rather meaningless. You're looking at your return in relation to a discounting factor that you could have had, from a like investment. Fine when you have known costs of inventories or securities that are graded and are of like kind, but RE is neither. I can tell what you'll receive from a AA bond over 58 months, no one can tell you what you will make on a RE purchased 58 months ago. Not applicable to a note unless you compare it to another note.

The computation as to the yield on a discounted note is the measurement to use. You're basically computing the APR and computed the same way as the IRR (which might be where confusion lies) in that you have a present value (your cost), a future value (the balance owed) and a note payment and you solve for the interest rate. This also is what you'll be breaking down for tax purposes as to the allocation of principal and interest.

If you buy a note with a 50% discount, then what you paid is your basis or cost of that investment. When a payment is received half of the amortized principal goes to your principal reduction or your cash paid out as the return to capital, the rest is profit and it is treated as interest on your investment. Cash on cash would then include the principal and interest received after reducing the amortized portion of your purchase price, that is the return of capital, not profit.

It is what it is and there is nothing more, buying notes at a discount can give an obscene return which should be plenty. Since the interest or profit is measured over an annualized term (360 days) a shorter term increases your return on your investment as a % in terms of an annualized yield, if the future value is received sooner than scheduled. What I did was purchased notes at a discount and then refinanced the note, often in less than 45 days. That sends my yield on that investment as an annualized yield to the moon! It makes your calculator smoke.

Doing any other ratio analysis for an investor of notes is going to be playing with your calculator and killing time, unless there is a need to compare different investments, I never cared about that, too busy going to the bank. :)