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The Importance Of Calculating Returns

GDNI 96 | Calculating Returns

 

One of the most important fundamental concepts in real estate investing is calculating your potential returns and using those numbers to determine whether or not a certain asset is worth the money and effort you’re going to be putting into it. There are so many different ways that you could be calculating your returns that it can get a little overwhelming, but worry not because Chris is here to save the day. Flying solo, Chris Seveney gets down to brass tacks about calculating returns and determining if you’re getting a good deal. Because these numbers are so important in making an informed decision about your investment, make sure you’re not left behind the curve. Let Chris help you make the best possible decisions you can.

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The Importance Of Calculating Returns

The Economy In Note Investing

For this episode, I am going to be flying solo. Hopefully, I don’t bore you to death, but Gail was not able to make it on this episode. Besides talking about what we see in the economy in note investing, I also want to talk about several different things being people projecting returns. There are a lot of terms thrown out there. ROI, Return On Investment, cash-on-cash, and yield. What do people use? What’s the best method for calculating returns? It’s a science but it’s inaccurate because you’re trying to predict the future. We’re going to touch more in detail on that.

We start off every show talking about what just happened. For me, I have a lot going on. We finished 2019 on a strong note and continue to stay strong in 2020. The year-end episode, I thought 2020 was going to be more challenging for note investors and the first two months of the year have proven that. I’d love to get people’s feedback out there to see what do you see in the markets with the Coronavirus having a major impact on travel tourism and the retail component. As we can see in the stock market, it had a significant drop in their predicting is going to be rough as well.

People are going to look more for safe havens, but also people are going to wonder what’s going on in the real estate world. Real estate is typically the last one to see the effect because it’s not something that happens instantaneously. When you think of the process of buying real estate and selling real estate, things that are closing now probably were put under agreement 30 to 60 days ago. Real estate typically is a few months behind. With interest rates at record lows, you’re going to see a lot of people refinancing, which I think is a good thing because it keeps people in their house and people aren’t selling. I know where I am, I was shocked because I got an email over from Redfin that the average days on the market in my zip code is under 45 days. Homes are selling at 99.7% of the list price. It’s good and bad. To me, it’s great from one standpoint.

Secondly, it’s a little scary how hot things are, but the inventory is extremely low. It is a seller’s market where I’m located. Real estate also is more micro economical in regards to where you’re located. Certain regions probably are a little slower than others. It will be interesting to see how the short-term rental market occurs, as this will be something that could definitely be impacted because of travel. People who are in short-term rentals, which is something I’m looking to get into if the price is right could have some serious effects. In regards to mortgage notes, I look at notes more in regards to jobs. People have jobs, they’ll typically be able to pay the mortgage.

A decade ago, there was a lot of job loss and that was what created a lot of the havoc. We’ll continue to monitor and provide updates of people on how things are going. There are a few other things on what just happened. Working on a lot of different components, we’ve got some REOs, which I still believe REOs are the most challenging as an investor, especially in notes. The more REOs that I do end up acquiring in the sense of taking properties back, the less thrilled I am with them. There was a point in time where I was going to take a bunch of REOs and turn them into rentals. Looking back at my business plan, it doesn’t fit my plan.

People are looking for more safe havens, wondering what's going on in real estate. Click To Tweet

It sounds like a great idea. It’s always great to have rentals for long-term growth, but if something doesn’t fit okay within your business and within your plan. That’s one of the hardest things people have and experience is to know when to say yes and know when to say no. Don’t take on too much. I was looking at converting 5 or 6 properties into rentals and they needed way too much work. The other component of it is trying to find a good contractor. I don’t care where you are. It’s nearly impossible. If you find them, keep them. It is difficult to find a good contractor. I also think it’s difficult to find a good realtor, but I’m not going to go down that road.

From that perspective, I don’t want to deal with it. It takes up way too much time compared to managing a note. Long-term, could it possibly have better benefits? Yes, but the true reality is being a landlord isn’t all rainbows and unicorns. There are a lot of costs that creep up on you that people seem to forget about. It’s not as lucrative as people find it to be. Long-term-wise if you’re going to do it, I think you’re better buying something more turnkey and of a larger scale, more than four-plus units that can provide a better return where you get a manager in place.

From that component, that’s a lot what I’ve got going on. Working in regards to the REOs. Tax-wise, all the 1099s and all the forms got out. They’ll do a little note and bolt for people because it popped in my head. This is important for people. When you provide 1099, think of it as who is getting paid. The reason I say that is I can’t tell you how many times I get 1099 from people. The 1099 is in their personal name when they’re using an IRA. If you’re investing in a fund or whatever it is, you send that to your bookkeeper and accountant.

The bookkeeper accountant doesn’t know, John Doe, who you are or how you’re getting paid and so forth and so on. They’re going to look at the 1099 and they’re going to run the QuickBooks report and say, “John Doe received $10,000 in interest.” If you fill that 1099 out with your personal name on it, you’re going to get a tax form saying you collected $10,000 in interest that you owe taxes on. You’re going to call the investor screaming at him and saying, “I use my IRA.” The investor is not responsible for you at the end of the day making sure you fill out the proper tax forms. Should they double-check? Yes, I have. I’ve gone back to people and I issued checks to people in the past that have like, “This is what you put on your 1099. That’s what I put in the system.”

They’re like, “This is what I use or this is what I paid you from.” It’s like, “That’s what the agreement was and I don’t know where the wire came from,” but at the end of the day, you’ve got to be responsible for that. It’s something that people could be cognizant of and understand that you’ve got somebody. My bookkeeper and accountant are 3,000 miles away. They don’t know whether it’s John Doe IRA or not. It’s what you filled out on that form. That’s something I want to make people aware of. If you’re using an IRA, fill out 1099 with your IRA. If you put in your personal name and then you get something saying you owe taxes, that’s probably the reason why. That’s a big one.

GDNI 96 | Calculating Returns
Calculating Returns: The real estate industry is one of the last markets to see the effects of a drop in the stock exchange because it’s not something that happens instantaneously.

 

I wanted to touch base in regards to the difference between ROI, cash-on-cash, and yield. A lot of people throw out these terms, especially newer investors don’t understand the difference between them. I’m going to break down somewhat, talk about the three, which ones I use and give people a high level generic, broad understanding of them. Let’s first start with cash-on-cash. Cash-on-cash is something that is in my mind, useless in note investing. It’s not something I view as anything to consider. Here’s the reason why.

Let’s say you have a note that you paid $10,000 for and it’s paying $250 a month. You are getting $3,000 a year and you paid $10,000 for it. That’s a 30% cash-on-cash return, but let’s say that there were four years left on loan. You’re going to get $250 a month for 48 months. What’s that turn out to be? It’s $12,000 over four years on a $10,000 investment. You’re cash-on-cash. I’m getting 30% of my cashback every year, but your returns are going to be extremely low. Another way to think about it, take a 0% interest loan that you gave somebody a loan for $12,000 at 0%, and they’re giving you $1,000 a month. Technically your cash-on-cash is 100%.

I got all my cashback in the first year, but you didn’t make anything. Cash-on-cash is how quickly you’re getting cash in the pocket. It’s not to be used for calculating your return. Back to that example of $10,000 getting $12,000 over four years. Would you rather have that or get $200 a month for twenty years? Which one do you think is going to provide a better return in that instance, but it’s got a lower cash-on-cash? I hope that explains things. When people toss out cash-on-cash, it shouldn’t even be in my mind being the discussion on note investing because it’s arbitrary in regards to yes, I’m getting 30% of my cashback, but it’s only over a short period. What am I making?

The two more common ones, you hear about our ROI, which is Return On Investment, and that can be done yearly and then yield. Also, IRR, Internal Rate of Return. ROI is your Return On Investment, which is in day one I put in $10,000. Two years later, I got $20,000. I got a 100% return on my investment. The one thing ROI does not take into consideration is time. There are 2D, 3D, 4D, different things. My wife and I bought a massage chair and there are different formats of it. They call it 3D and 4D, which the difference between it is the fourth dimension is the speed at which the rollers go. Look at things from different perspectives.

ROI is like between yield. I view it as a 3D versus the 4D. It tells you how much you’re making, but what’s that period of time? If you’re in investments that are providing one lump sum and are going to be resolved within 6 to 18 months, maybe even up to 24 months, ROI isn’t bad at all because you are getting a lump sum payment. The yield is more on a cashflow basis. It’s for a year or two. If you’ve got $20,000 and you may put in $10,000, you’ve got a 100% return over two years. You made 50% per year. As you start extending that time period, there’s what’s called time value of money, which we all know a dollar is worth a lot more than a dollar years ago.

Whether ROI or IRR, you're just using those numbers to determine a bid price. Click To Tweet

In history it has shown us that with inflation, we don’t have deflation, things cost more. What did a gallon of milk cost years ago compared to now? That $1 was worth a lot more back then. That’s where yield plays into a benefit later on down the line versus ROI. Strictly for ROI, it’s not a bad thing if you’re buying a nonperformer, you’re thinking about foreclosing. Let’s say you pay $20,000 for it, you may have put $7,000 into it. It’s got a $50,000 UPB and property value. You end up being in this thing for $30,000-plus, and then after selling and stuff you create $40,000, in that year you made $10,000 on a $30,000 investment, you had a 33% ROI.

When you look at what yield would be on that instance, it’s probably going to be close from that perspective. In the nonperforming side of things, ROI or Return On Investment, I personally don’t use it, but I don’t see a downside in those instances. There are some hardcore IRR people who will tell you to go IRR. At the end of the day, it’s not going to make that much of a difference. I think what people need to remember is you’re using these numbers to determine a bid price. You’re typically working backward to create a bid price based on a set return you want to make. I say that twice because it’s a return you want to make. How you calculate it is your business.

Secondly, is it’s a forecast or an estimate like we estimate how much rain we’re going to have. We’re going to estimate what the stock market does. The one thing that’s different with this is you also have a seller on the other end that wants to get a set price for their asset as well. That’s one of the dynamics, that also plays into it. I was having a conversation with a woman who read the blog and said, “You came up with a quick cheat sheet on a rough number how to bid on an asset.” I said, “You can take the principal and interest payment and multiply it by 30 or 40, and that’s your range. Take that and the 55% of the UPB and fair market value and whatever’s the lowest of those, that’s your range.” Someone was like, “What do you mean?” I said, “If you take a payment times twelve months and divided by 0.4, it’s 30.” You’re taking the twelve months of payments and trying to target a 40% return, which is not 40% because of servicing and other costs and stuff, but it’s a ballpark. Let’s say you go to 30%, that’s a range. If the principal and interest payments are $300, you should be paying between $9,000 and $12,000 for that asset. This is nonperforming.

That’s your range, $9,000 to $12,000. If the UPB and fair market value are both $50,000, I’m not going up to 55% on that because if that person starts to reinstate and you paid $30,000 for it, look how long it’s going to take you to get your money. Your yields are going to be super low from that perspective. If the UPB is $12,000, I’m not going to bid 100% of UPB. I’m probably going to bid 50% maybe or $5,000 to $6,000. That’s why I always throw that kicker of 50% to 55% of UPB or property value. Let me give you two examples because it may sound confusing. You have a property alone that has a principal and interest payment of $300.

It’s got a UPB of $30,000 and a fair market value of $40,000 and nonperforming. It’s a year behind. People will say, “I’m going to pay 50%, 55% of the UPB, which is $15,000,” which probably the seller might want $20,000, I don’t know. It’s got equity in the deal. It’s got a $40,000 valuation, but the principal and interest payment is $300. 55% of $30,000 is $16,500. That’s one number that pops in my head. I multiply the PNI by 30% and 40%, which is $9,000 and $12,000. I’ve got three numbers, $9,000, $12,000, and $16,500. Which one do I bid? Typically I will start at between $9,000 and $12,000.

GDNI 96 | Calculating Returns
Calculating Returns: If you’re in investments that are providing one lump sum and are going to be resolved within 6 to 18 months, the ROI isn’t bad at all because you getting a lump sum payment.

 

Would I ever go up to the $16,500? Probably not to be honest with you. It’s because if that borrower all of a sudden starts repaying, let’s say they even reinstated or came close to reinstating, which chances are typically unlikely and they paid $3,600. You could say $16,500 minus $3,600 brings you down to $12,900, which is close to your $12,000. You’re right, but you’re also gambling on that. Also, others will say, “The borrower is a year behind, you can turn around and foreclose on them. You’re going to get a $30,000 UPB, your profits are going to be much higher. Why wouldn’t you pay more?” I said, “Because I go back and I look at risk.”

Set Up Your Calculator

A lot of people forget about risk in this. I know I digressed on that a little bit and jumped off-topic. I do want to do one as well for people. Let’s say it’s $300 a month, but the UPB is $10,000. What am I bidding on that asset? Multiply it by 30% and 40%, you’re at $9,000 and $12,000, I’d probably be bidding around $0.40 on the dollar. It depends on the fair market value, but I wouldn’t go more than $5,500, which is 55% of UPB. Maybe $6,000, but if that probably was like $50,000 or $60,000, not much higher. Back to ROI, return on investment. It depends on how you want to set up your calculator when you are starting out. It’s not a bad thing for nonperformers to use ROI. I don’t use it, but there’s nothing wrong with those who do. I’m going to jump into yield, which is also an internal rate of return. That’s an interest rate you’re paying yourself, and 99.9% of people use it incorrectly.

Readers are probably thinking, “What do you mean use it incorrectly?” There are several reasons. Here are the top three reasons why I see people use it incorrectly. One is they take the principal and interest payment, not the net payment that they’re getting. If it’s $300 a month PNI, your servicing says $20 a month, you’re only getting $280. The second component to this is if you’re buying a note on your own, IRR is cashflows in and out. How accurate are you putting it? If you’re paying force-placed insurance and you’re only getting reimbursed for that every three months, are you putting that into your calculator? I don’t, but it’s not going to give you the right answer. In the sense of when you put it in, they’ll get a 15% return because, “I have more money going out the door than that $280 coming in.”

I’m paying $40 a month on insurance. What happens is I’m getting $240 a month and then every four months when my servicer pays me back, I get a bigger chunk of money coming in the door. Why is that important in the sense of yield? Yield assumes that the money getting in is being reinvested at the same rate. In Excel, you can use XMIRR, which is I use. I have a fancy plugin for it that I can put in what the interest rate is that things are being reinvested in. I keep it low for those purposes. Let me give you an example and let me talk a little bit more about IRR. It’s an interest rate you’re paying yourself.

You know you’re putting $10,000 in a deal, you’re assuming in three years you’re going to have $20,000. The time that you get to that $20,000 is different. If you paid $17,500 for a note, that has a principal and interest payment of $400 a month and it’s going to go for 63 months. You get $17,500, you buy a note paying $400 a month, 63 notes, and then it expires. If you plug a simple IRR calculator in Excel, $17,500 and then $400 a month until the end, that’s a 15.68% return. It’s not bad for a performing note but you forgot to include the servicing. Let’s say your servicing is $20 a month. All of a sudden, your return is 13.2%.

Yield assumes that the money being put in is going to be reinvested at the same rate. Click To Tweet

Let’s say you use the servicer’s charge is $35 a month because you’ve got less experience and you want them to do the workouts and so forth. All of a sudden, your returns are 11.3%. It’s gotten down quickly from over 15% down to 11% for servicing. Here are several things that we haven’t taken into consideration yet. One is most people when they put these numbers in, figure the person is paying on the first of the month, which maybe they are. How long does it take the servicer to get you your money? Some servicer pays instantly, some wait two weeks, some wait about five weeks. I know one that makes a payment on the first. I’m not seeing it until the third week of the following month. It’s time value of money. They’re holding your money for a month.

The other component to it is, let’s say that money went back into a bank account or your IRA. You did nothing with it. Let say it was even paid on the first of the month and then it gets paid off. Once everything is paid off, you turn around and invest it. What’s your yield at that point in time? It’s 7%. By not reinvesting the money over five years, your returns have gone from 15% to 7%. The reason I’m saying this to people is a lot of people use calculators. Like me, I’d target a 30% yield on nonperforming and 15% yield on performing. The accuracies and inaccuracies of it are sensitive, especially over shorter periods. It’s not an exact science and don’t get hung up in the calculator in the sense of at the end of the day people want to know I put in $20,000, I made $7,000.

People don’t care whether their IRR was 2%, 4% or 6% or whatever the IRR may be. Once in a while someone may, but most of the time they want to how much you made. If you’re JV-ing with somebody, you’re the person handing out the money. They’re only paying you quarterly. A 30% yield is not 15% and 15%, because they’ve got no money in the deal so the sponsor’s yield is infinite. Yours isn’t half of that because you’re the one putting in the money. What are your payment streams? For the most part, it’s probably low.

That’s why when I did JV deals with people, I would give them the money upfront that came in the door until they got their equity paid down because it enhanced their returns, which is something that you could do. It’s another avenue of it’s all about the cashflow coming in and out. I apologize if this episode has gotten high-level. The moral of the story that I’m trying to get to people on this is calculating your returns. There are different ways to do it, but none of them are accurate at the end of the day. I spent way too much time on my calculator and I love my calculator. I can still refer back to it, but for the most part, I can look in an asset and I know what I’m going to bid based on seeing thousands of assets in that price point, price range.

Starting out, it’s good to understand, but you’re better off, in my mind when starting out, understanding what your costs that you’re going to incur are and trying to figure out what your return is going to be. Most people will sit there and put a fancy calculator together, but they have no clue how to incorporate and understand costs. For example, if you’re buying a land contract in certain states and say it was a $20,000 balance, but the property has a tax value of $200,000, those tax stamps are based on the tax value, not what you’re paying for it. You could have a $4,000 fee when you go to record that deed that you can take into account. All of a sudden, you have a $20,000 note and you’ve got a $4,000 bill.

GDNI 96 | Calculating Returns
Calculating Returns: When you’re calculating your returns, you have to remember that while there are different ways to do it, at the end of the day, none of them are absolutely accurate.’

 

That’s 20% of your costs that you didn’t figure. It’s probably going to leave a little bit of hurt in that return. Focus more on the costs. You go back to that, multiply it by 30, 40 and 0.55, that’s your window, that’s your drive lane on the highway of how many lanes you’re driving for the most part, most of the time. Some of those mistakes I see people do or make is a UPB, a modified loan at 2%. The payments are $300 a month and it’s got $70,000 balance. People are going to pay them $40,000, $50,000 for that thing and I’ll look at it and be like, “They’re nuts.” The person is four months behind, you’re not going to be able to foreclose.

They’ve got tons of equity. What are they going to do? They’re not going to let you foreclose, they’re going to go bankrupt. They’re a year behind at $250 a month payments. You’ve got $3,000 spread out over five years. You’re getting an extra $50 a month on top of the $200 or whatever it is. It’s $200 something a month to collect your $40,000 back. How long is that going to take? Twenty years to get your money back? That’s why you’ve got to be careful, especially a lot of those loans, I don’t even look at it because I know the seller is going to want way too much money for them. Sometimes I’ll throw an offer at them.

It’s usually low and there’s somebody else that’s out there who’s inexperienced is going to make that mistake that they’re going to overpay for a low UPB alone. I apologize if my engineering high level came too much into play. The moral of the story is to take cash-on-cash, throw it out of the window. ROI starting out isn’t a bad thing. If you want to get sophisticated and do yield, which I’m performing notes, you should honestly do yield. I didn’t talk a lot about that. You can just PV formula, Present Value formula in Excel, which would tell you what you should bid on it. If you go to 7EInvestments.com/freebies, I give you a calculator that does that for you.

A lot of people get hung up in yield. Two notes I’ll leave on this is, first, besides looking at the numbers, you need to evaluate the risk. What’s the risk of that asset? What’s the risk of something happening? Are you banking on too much to happen to get to the numbers? People forget about risk. I see far too often people don’t take the risk into account, which can be detrimental. The second thing and this is about yield. Typically where yield is used, it’s a compare asset. You use the same data points or datasets in regards to payments, months and comparing two apples together and which one is going to provide a better return.

That’s where yield is used in a lot of industries. I have a multifamily deal that is creating an NOI and here’s what it’s yielding. I have the opportunity where I could sell it to buy another deal. You’re looking at it, if I sell it for this much and then buy this other deal, you know how much you can sell for roughly. You know how much you can buy that other deal for. Are you better off doing that? Similar to a note. I’ve got a performing note. I can sell it for X and I can turn around and buy another note for Y. Am I better off? Is it going to provide me a better yield? That’s one thing to be cognizant of. I had somebody who we did some deals together who was focused on turning the money around, buying assets and a bunch of performing, turning around and reselling them.

There’s nothing wrong with that. In the long-term, it would have been much better off because these were performing and they were bought at a good price, collecting that cashflow and then deciding when you have something, “I have another deal that is 60 days away. Let’s try and extinguish these things.” What may happen is, especially in this economy, you don’t have that deal to go to. It’s like, “I’m going to sell this asset and then my money is going to sit at my bank account at 1%. I would have been much better off collecting 8% yield before you sell it or whatever it is. Those are things people need to think about and determine as well. Sometimes people are in a rush to get out of a deal and get their money, which I am a proponent of a bird in the hand has been two in the bush, but also if you have something that’s still going well, if there’s no place to move to, stay where you’re at. That’s probably where the rest of it goes back to the best risk. I hope you enjoyed this episode. Any questions, comments, please feel free to reach out to me, Chris@7EInvestments.com. As always, go out and do some good deeds. Thank you.

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