The Truth About ROI (aka Your Rate of Return)

In this article

“82% ROI, come and get it!!” (yells through megaphone, waves flag…) Can you picture it? I can.

Who wouldn’t want an 82% return on investment? You’d have to be out of your mind to say no to that. Well, then why do people say no? Because what a seller claims the rate of return (ROI) on a property to be may not be completely accurate.

Two Reasons a Seller’s Claim on ROI Might be Bunk

1. The calculations or assumptions the seller uses to come up with ROI may be misleading or inaccurate.
2. The tenant quality may be so bad that there is no feasible way to realistically get the advertised return due to evictions, vacancies, and repairs.

How ROIs are (Should Be) Calculated

No calculated ROI is for sure, but there are ways to make it as accurate as possible. Conversely, there are ways make an ROI look really stellar. While not technically lying, sellers often reply on assumptions that can’t possibly be that accurate. Maybe in fantasy land, or years ago before the market crash, but making some of these assumptions today has to be the stupidest thing an investor can do.

 “Dude, this property has an 82% ROI!”

“Really, how do you get to that number?”

“Not sure, but doesn’t an 82% ROI sound awesome?  You should buy it and then you can tell people you are making an 82% ROI.”

What are some of those assumptions?

• Appreciation Expectations. I shouldn’t even have to elaborate on this one. Appreciation used to happen pretty nicely, but as we all learned just a few years ago, it’s far from guaranteed! So don’t even include it in your “ROI”. Please. (more like puh-lease)
• Depreciation and Tax Benefits. Yes, these come with real estate investments, mostly rental properties. I agree that these benefits are definitely part of your overall ROI, but trying to calculate them into an actual number is just a ridiculous stretch. Consider those benefits (and they are nice ones!) as bonuses. Never rely on them to justify buying a particular property. Plus you never know from year to year what changes to the tax system the government will make so don’t rely on today’s tax rules for tomorrow’s return. {looking you, Obama…}
• Mortgage Pay-Down Assumptions. These are great if/when they happen, but you still don’t know what the exact situation will be later, so relying on these is really stretching it too.

I’m sure there are plenty of other assumptions floating around out there. The big one that really sticks me in the side is when I see appreciation charts as a justification that a property is a good investment.

The First (and Only) Rule of Investing

Don’t lose money.

Simple, huh? I think so. But apparently it’s not because people lose money all the time. Never rely on the hypotheticals, the assumptions, the what-if’s, the anything. Cash flow matters. Cash flow you know. Appreciation you do not. Tax benefits you do not. Fancy inheritance you do not. Work for cash flow. If you can set yourself up to buy a property that for sure cash flows but then also has a nice appreciation potential, do it. That’s what I shoot for. I don’t by $20,000 properties because they will doubtfully go very far up. $100,000 properties, on the other hand, very likely to go up. I also don’t buy $20,000 properties because of the tenant quality. Bad tenant quality makes you lose cash flow, and the number one rule is not to lose that.

Final Thoughts

Always question a seller’s ROI calculation.

Use only known and realistic assumptions in your calculations.

Shoot for cash flow only and consider everything else a bonus.

Make sure you factor in vacancy and repairs, based on tenant quality and property condition, into your cash flow calculations.

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