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08: ROI, COC, IRR etc.

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In the investment world, you will often hear the terms ROI or cash on cash. ROI stands for return on investment. That means how much yield you are getting on your money in a given investment. Cash on cash (COC) is a little different and it is probably best to use the example of real estate to explain how.

Say you invest 20K into a 100K property that has an 80K mortgage and your cash on cash return is 10 percent. That means that after you paid the mortgage, principal, taxes, and expenses on that property, you ended up with 2K of cash flow to put into your bank account. That is cash on cash. Why is that NOT ROI? Well, ROI includes ALL of your return, not just your cash flow. In this case, every month you pay your mortgage, you are also increasing your equity position in the property by paying down debt. True ROI includes the increase in equity as part of the calculation so ROI will be higher than cash on cash when debt is used. Often you will hear ROI and COC used interchangeably which it should not.

One other term that is often used in real estate is internal rate of return (IRR). You will see this when people make projections of property performance on an asset over time. So, you might hear cash on cash is 10 percent but five year IRR is 20 percent. Formally, IRR is a relatively complex theorem that includes such esoteric variables as the time value of money, etc. In my experience, however, it is rare that someone who says IRR MEANS IRR. They usually mean annualized return.

Ok Buck, so what is annualized return? Well, if I tell you that cash on cash is 10 percent and annualized return is projected at 20 percent over 5 years, I am telling you that you can plan on getting about 10 percent of your investment per year as cash flow. Then, at 5 years, we will sell the property. Because we will have paid down some of the mortgage and because we will sell the property for more than we bought it, you will end up with a lump sum that, when combined with your cash on cash returns over 5 years, will actually average out to a 20 percent return on investment per year over the course of 5 years.

Get it? Read it again if you don’t. Now remember, most of the time people who say IRR actually mean annualized return. Even I do that sometimes and now you can call me on it!