Why You Shouldn’t Use ROI for Comparing Real Estate Deals

It’s common for small residential real estate investors, especially new investors, to compare deals in terms of ROI (return on investment) and talk to other investors about their cash-on-cash return. And often, ROI is indeed the sexy attractive number, 10%-20%, investors are going for in the end, but using it to compare deals and to make a purchase decision can lead to terrible outcomes. This article will dive into this common mistake for new investors and present a better way to understand any deal that comes to you.

Why ROI isn’t good for comparing the deals

ROI is the final return on investment after the financial leverage. When you take a loan to buy an investment property, you are making leverage on your investment. The higher the loan-to-value ratio is, the high of leverage is. So, with different financing costs and leverage ratios, the ROI will be different for the same deal. Therefore, you can simply archive a higher ROI by using higher leverage. For example, for a 200k investment property with a 4% financing interest rate and 20% down, your ROI will be about 15%. But if you were to drop your down payment to only 5%, the resulting ROI will become 24.8%. In the end, this is still the same property we are looking at.

To understand why ROI isn’t good for comparing deals, we need to understand what leverage means and how to use it effectively. In the context of purchasing an investment property with leverage, it’s borrowing money at a lower interest rate to make a higher return investment. Let’s say that there is an investment property that’s estimated to return 10% every year, I can either invest my own money and make a 10% gain on what I have, or I can take leverage by borrowing money from others at a rate less than 10%. By taking leverage, the return is, theoretically, unlimited as long as the financing costs are lower than my expected rate. Thus, the key is to have a sufficient spread between the financing interest rate and the estimated return.

While we do not have much control over our financing costs, we can always try to pick the deal that has the best all-cash return (Cap Rate). Then, as a result, it would be the best deal no matter how much leverage we are taking or what’s our financing interests rate.

Cap Rate, Then ROI and DSCR

For new investors to buy an investment property, instead of chasing ROI without understanding all its underlying assumptions and risks, it’s better to focus on Cap Rate first. Cap Rate is the rate of return one would get if the property were bought with cash, without leverage. Using cap rate as the purchase criteria ensures that the property being purchased is a good-performing asset. After getting the property under contract and setting the cap rate baseline, we can then think about the amount of leverage to take on the particular deal.

The way we think about leverage has to be combined with the risks associated with it. In real estate, the term DSCR (Debt Service Coverage Ratio) is a standard way to measure it. DSCR is telling us the ratio between the expected monthly revenue to the expected debt service cost (typically including mortgage, property tax, and insurance). If the ratio is barely over 1, it would be a very risky deal to pursue, because any downward fluctuation in our income would result in a negative cash flow. Therefore, we will want to see a DSCR number much higher than 1. With the cap rate baseline already set in place, and loan interests rate we have limited control over, we can only affect the DSCR through the leverage ratio, with different down payment amounts. After all, it’s not just about ROI, it’s about balancing the return (ROI) and riskS(DSCR). Each investor is different when it comes to risk-averse vs risk-seeking, but it’s important for all investors to understand the trade-off between return and risk.

Conclusion, also TLDR version

While scanning the market and trying to find a good deal to buy, investors should use the cap rate for comparing deals. After the property has become under contract, investors should understand the trade-off between return and risk and choose the strategy that’s the best suited for them. For risk-seeking investors who are looking to expand their portfolio quickly, they can go with a lower down payment, which would result in a better ROI (better cash-on-cash return) but DSCR closer to 1(riskier). For risk-averse investors who are looking for good cash flow and less management overhead, a bigger down payment, results in a relatively lower, but still good ROI and higher DSCR. To calculate the Cap Rate, ROI, Cash Flow, and DSCR, investors can use PortfolioBay’s free deal calculator to get a quick estimate and be confident in making sound investment decisions.