The Fallacy of Return on Investment

by Mr. Cheap

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Return on investment (ROI) is a popular, useful way to evaluate an investment. Simply, it’s the return you get from an investment, divided by how much it cost you. E.g. you buy a GIC/CD for $1,000, a year later they return your $1,000 and give you $50 in interest, you’ve got a 5% (50/1000) return.

I’ve posted before on my ROI from my condo (calculated at the 6 month mark – once I’ve done my taxes I’ll post about what it looked like at the 1 year mark). Going into the future, some of my expenses will drop (my mortgage is continually decreasing, I got a break on my insurance when I renewed) and my income (rent) SHOULD go up.

Will this mean that I have a continually increasing ROI? Many people would say yes and that’s part of the reason its supposedly great to invest in real estate, but I think there’s a problem with this line of thinking. I’ve wrote about this fallacy as it relates to stocks, but I think it’s broader than that.

Say I bought a condo for $100k 10 years ago and you bought an identical condo for $150k yesterday (which is the fair market value for both of our properties). Say we both rent our condos out for $1300 / month. My ROI is 15.6% (1300*12/100000) while your’s is 10.4% (1300*12/150000). We’ll ignore all expenses just to convince everyone that real estate is a magical, perfect investment vehicle.

Now say we both come across another investment offering a ROI of 13%. Using just ROI, rationally someone might say you should sell and move your money into the new investment, while I should keep my condo. But our condos and rents are the same, so how could it make sense for one of us to pursue an alternative investment but not both of us?

The problem with this thinking is that it’s considering my condo to be worth $100,000 when its not. Its now worth $150,000. The only reasonable way to think about this is to consider the CURRENT value of the condo (look at the opportunity cost). The purchase price is totally irrelevant (except perhaps for tax calculations and whatnot).

I’ve done various calculations on my condo return. Its looks great (over 7%) when I consider the purchase price (around $130k depending on whether you factor in the cost of renos and transaction costs). It looks pretty meager (around 4%) when you look at the ROI based on the current value of the condo (similar units are selling for an ASKING price of more than $160k – I don’t know what they’re actually selling for).

I got a good price on my condo when I bought. That transaction is finished however. I can’t claim that I keep benefiting from a good purchase price into the future as long as I own it (or I can claim this, but I’m fooling myself). I could have bought it, fixed it up and sold it (flipped it) and captured this increase immediately. The decision whether to sell or rent should be based on the market value NOT on the purchase price.

I came across a mistake in the opposite direction in a real estate book I was flipping through recently. The author claimed that you should base you ROI on your equity (current value – current mortgage) which I agreed with (the current value part anyway). However, he also considered positive cash flow as the income and reached an unusual conclusion. Say you bought a $100k property for 5% down ($5k) with a $1000 / year positive cashflow. His claim was that you start with a ROI of 20% ($1000 income / $5000 equity). Fair enough. He then speculated that a year later the property value AND the income went up 10% ($110k property, $1100 / year positive cash flow). His claim was that your ROI was now 7.3% ($1100 income / $15000 equity) and you needed to sell. The problem with this is that your leverage is massively affecting your ROI in a way that certainly doesn’t smell right to me (if you could get a property for 0% down with positive cashflow his calculation would claim that’s an infinite ROI). To my mind the investment is almost exactly the same as the day you bought it: the income and the value have gone up an equivalent amount, so why sell?

Personal yield on stocks, as I wrote before, is exactly this fallacy (one of the commenters on my previous post claims this fallacy is called “mental accounting”). Your personal yield is meaningless (for anything other than making you feel good about the investment). The dividend yield, based on the current stock price, is what is meaningful if you want to evaluate the ROI of an investment going forward (again: this is ignoring the tax drag, which should be included if you’re actually thinking about selling).

Just to be clear, I don’t think ROI is a fallacy, I think it’s a very important concept. However, I often read statements that make me worry that people are misapplying it.

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{ 6 comments… read them below or add one }

1 Four Pillars

Your example of the two rental properties shows your point perfectly.

I guess return on equity is a much better indication of how good the investment is doing.

Mike

2 Kyle

I agree completely. ROI is fine the first year, but after that becomes irrelevant. For real estate, Return On Equity is definitely the way to go. For stocks, Compound Annual Growth Rate is the best way to measure total return because what you’re really interested in is how quickly your investment has compounded over time and not how large this year’s gain was relative to what you paid for it 7 years ago.

I agree with the real estate book you cited. In my opinion, that is the correct way to calculate it because you can’t decouple leverage from your investment returns. One will always affect the other. It makes sense that as your leverage decreases (and it has because you now have more than 5% equity), your Return on Equity will also decrease.

3 Mr. Cheap

Elliott: That becomes the issue in the second example I gave. For comparing the two condos, just assume they’re both owned outright to keep it simple.

Leverage can have some funny implications on your calculations (as I tried to show in the second example).

4 FinancialJungle

Great explanation, Mr. Cheap. Mental accounting is probably my #1 pet peeve in personal finance. Often, people who fall into this trap don’t appreciate your help in getting out of it.

5 Ron@TheWisdomJournal

Preach on my brother!
Would you mind explaining this to our board of directors, the CEO and the VP of Operations where I work?

I can’t seem to get this through their heads.

6 Karl

so let me run a scenario by you…
if two partners agree to buy a house as 50% co-owners.
purchase price $200k
partner A puts up the 20% down payment of $40k and incurs no operating expenses
partner B lives in the house paying PITI of $1500/mo plus repairs/maintenance

10 years in future partner B purchases the other 50% from partner A at market rate of home being $300k
what is ROI for partner A?

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