Have you ever been presented an investment opportunity and had no idea how to determine whether the deal was good or not? When we are presented investments, we are often forced to examine options that have many different numbers and these different numbers make it very difficult to quantify the opportunities.
Ultimately, when we get down to it, the goal of investing is to make an "apples to oranges" comparison and turn it into an "apples to apples" comparison. To be able to make an "apples to apples" comparison, it is essential to turn the investments into one common variable. This is where people often get into problems. The reason that they get into problems is because they do not know how to boil down the two opportunities into one common variable.
Here, we are going to discuss one way to do this, and that is by calculating the cash-on-cash-return-on-investment ("ROI"), which means how much is one getting back from the actual cash invested. In this example, Terry is looking to buy a rental property and is presented with two investment opportunities.
Both are rental properties, identical build, year, size, etc. and both are located right next to each other. Both are for sale for $100,000 and both rent for the same amount and have the same rental expenses. Both are also offered with 30 year financing with the same interest rate.
The only difference between the two properties is the down payment required, which consequently affects the monthly cash flow that each produces. For property A, assume that it requires a down payment of $10,000 and produces a net monthly cash flow of $70/month into Terry's pocket. Assume Property B requires a down payment of $15,000, and produces a net monthly cash flow of $95/month into Terry's pocket.
This is the "apples to oranges" situation discussed earlier as both have two different variables that do not match up: different down payments and different monthly cash flow. So, we now have to boil these two investments down to their cash-on-cash-return-on-investment to make a legitimate comparison. To do this, we will have to pull out our trusty 10bii financial calculators.
Answer: These are the buttons to push into your 10bii financial calculator
N (number of months) = 360 (This is the time frame of the loan.)
I/YR (interest rate/year) = ???? (This is what we are solving.)
PV (present value) = -$10,000 (This is the amount that Terry would have to come out of pocket to buy property A. This number is negative as this money is leaving Terry's pocket to purchase the property.)
PMT (payments) = $70 (These are the monthly payments that Terry receives every month.)
FV (future value) = 0 (There is no lump sum/balloon payment that Terry receives or that he has to make at the end of 30 years.)
After entering these numbers, the I/YR = 7.51%, meaning that Terry will have a cash-on-cash-return-on-investment of 7.51% if he decides to purchase property A.
Now, let's examine property B.
N = 360 (Same length mortgage as Property A above.)
I/YR = ???? (This is what we are solving.)
PV = -$15,000 (This is the down payment hat Terry would pay for property B.)
PMT = $95 (These are the monthly payments Terry would receive from Property B.)
FV = 0 (No balloon at the end.)
After entering those numbers into the financial calculator, the answer comes out to 6.52%. Meaning that if Terry bought Property B, his cash-on-cash-return-on-investment would be 6.52%. This is approximately an entire percentage point less than the return that Terry would have received with Property A, which was 7.51%. So, Property A has a higher cash-on-cash-return-on-investment than Property B. With this information, Terry now has a legitimate way to compare these two deals to see which one is the better (or that he prefers) of the two.
Ultimately, this comparison takes the "apples to oranges" comparison (different down payments, different cash flow) that we had at the beginning of the example, and makes it into an "apples to apples" comparison (different returns on investments), which is much easier to understand. Granted, there are other factors to consider besides cash-on-cash return. However, this is a good place to start and it gives an investor the ability to find a point of reference for analyzing an investment opportunity so that they are not making decisions based on guesses. The ultimate goal as investors is to eliminate guesswork and speculation and to make educated decisions with the information presented.
How do you evaluate investment opportunities? Do you have any questions or comments about this evaluation? Please comment below as I would like to hear your thoughts and I will respond.