Question

This week's discussion is about valuation of company assets for purposes of computing return on investment (ROI). Use the following scenario for your discussion: A company owns two identical apartment buildings. Both buildings were built at the same time. The first building was acquired by the company ten years ago. The second building was acquired by the company two years ago at a higher price. The net book value of the first building will be much lower than the net book value of the second building due to accumulated depreciation and a lower purchase price. Each building has a different manager. For your post, prepare 3–4 paragraphs about managing these properties. Discuss how to measure the ROIs so that the manager of the older building does not show a much higher ROI, even if actual job performance is worse in terms of keeping the units rented and containing maintenance costs.

Answer 1

A.

Return on investment (ROI) is an accounting term that indicates the percentage of invested money that's recouped after the deduction of associated costs. For the non-accountant, this may sound confusing, but the formula may be simply stated as follows: ROI = (Investment Gain-Investment Cost)/ Investment Cost.

But while the above equation seems easy enough to calculate, with real estate a number of variables, including repair/maintenance expenses and methods of figuring leverage—the amount of money borrowed (with interest) to make the initial investment—come into play, which can affect ROI numbers. In many cases, the ROI will be higher if the cost of the investment is lower. When purchasing property, the terms of financing can greatly impact the price of the investment; however, using the correct type of mortgage, can help you save money on the cost of the investment by helping you find favorable interest rates.

Complications in calculating ROI can occur when a real estate property is refinanced, or a second mortgage is taken out. Interest on a second, or refinanced loan may increase and loan fees may be charged, both of which can reduce the ROI. There may also be an increase in maintenance costs, property taxes and utility rates. All these new numbers need to be plugged in and the ROI recalculated, if the owner of a residential rental or commercial property pays these expenses.

B. How to measure the ROIs if the identical buildings.

Let's look at the two primary methods to calculate ROI: the Cost Method and the Out-of-Pocket Method:

The Cost Method

The cost method calculates ROI by dividing the equity in a property by that property's costs.

As an example, assume a property was bought for $100,000. After repairs and rehab, which costs investors an additional $50,000, the property is then valued at $200,000, making the investors' equity position in the property $50,000 (200,000 – [100,000 + 50,000]).

The cost method requires the dividing of the equity position by all the costs related to the purchase, repairs, and rehab of the property.

ROI, in this instance, is $50,000 ÷ $150,000 = 0.33, or 33%.

The Out-of-Pocket Method

The out-of-pocket method is preferred by real estate investors because of higher ROI results. Using the numbers from the example above, assume the same property was purchased for the same price, but this time the purchase was financed with a loan and a down payment of $20,000. The out-of-pocket expense is therefore only $20,000, plus $50,000 for repairs and rehab, for a total out-of-pocket expense of $70,000. With the value of the property at $200,000, the equity position is $130,000.

The ROI, in this case, is $130,000 ÷ $200,000 = 0.65, or 65%. This is almost double the first example's ROI. The difference, of course, is attributable to the loan: leverage as a means of increasing ROI.