ROI (Return on Investment) is a simple calculation that all investors should have an understanding of. You look at the net profit after all expenses are paid, compared to your overall cost of investment. This can be calculated on a year to year basis.
ROI is relatively easy to calculate and understand, and its simplicity makes it a standardized, universal measure of profitability. One disadvantage of ROI is that it doesn’t account for how long an investment is held.
IRR (Internal Rate of Return) is quite a bit more complex when it comes to the formula…
Yikes! However, understanding the formula is not as important as understanding the basic concept. When you calculate the IRR of an investment, you are effectively estimating the rate of return of that investment after accounting for all its projected cashflows together with the time value of money. This is important when looking at a real estate transaction where you are looking to hold the property for more than one year.
The main drawback of IRR is that it is heavily reliant on projections of future cashflows, which are notoriously difficult to predict. It is also extremely complex in its formula, so if you’re not a math geek (and let’s face it, most of us aren’t), it may be a difficult one to understand.
All in all, these are still only two of the metrics we use when analyzing a potential investment (albeit, two of the vital ones). It’s important to at least be familiar with these metrics and to have an idea of what you return ranges you are looking for.
Even investing passively requires some upfront education so you can make wise, informed decisions. And as always, don’t hesitate to reach out if you have any questions!
Until next time… happy investing 🙂