Previously we discussed how returns on lending platforms are amortized. An exact calculation of returns can be complicated. It is not as simple as the quoted annualized return stated on many deals for the individual investor. As Reamerge is a peer lending platform, investors should be aware of the calculations.
The simplest of calculations is Return on Investment or ROI. Mathematically its
ROI = (α – β ) / α
where α stands for an arbitrary ending balance and β is the initial invested balance.
It would work something like this – you invested $3,000 and a year later that grew to $3,300. Based on formula above your return was 10%
Is it that simple though?
Most of the folks on peer lending platforms or real estate crowd funding platforms use their accounts as CASH MANAGEMENT system. This will be discussed in a separate post, but a short snippet would give you an idea (this is more of a reality than above simple scenario)
You invested 3,000 beginning of the year, say in January/February on a real estate crowd funding portal. Assume that it was a debt based investment. Then five months later you add another $1000 to your account and invest that in another deal/loan. In subsequent months though you needed the money and you extracted $1,000 dollars out of your account. At the end of the year your account shows $3,300.
What is your ROI? Well, per above formula its 10%
Is that so?
Remember you invested an extra $1,000 on top of your $3,000 for a few months. Just intuitively it must be less then 10%.
This highlights the short comings of ROI – what is actually happening here or happens in the real world?
Any investment where the account has activity i.e. money moving in and out is essentially ignored by ROI calculation. ROI will only look at the end cash and starting cash.
A practical example in real estate example is you may have bought an asset – say commercial property – receiving monthly cash flow for 2-3 years. You decide to refinance and cash out a portion. However, there is unexpected extra costs of repairs you did not account for and you have to pay out of pocket for a couple of months for these (shouldn’t have cashed out!). After 7 years you are sick of tenants bothering you and you sell the property for a decent profit.
All of the cash movement above is not captured by ROI.
Time Value of Money:
FACT: A dollar earned today is worth more than one earned tomorrow.
Money is simply more valuable today than in any time in the future. The explaination can be complicated but on a basic level this is due to inflation and buying power erosion. Even if your ROI is 10%, inflation may eat up 2% from that yield.
ROI does not take this into account.
One more concept is that of an opportunity cost – you locked up your investment in a Lending Club loan for 3 years at 8% but what if there is an equal risk profile investment that is yielding 10%? You missed out but does your account reveal that? ROI does not.
How can we better calculate the account fluctuations of cash through a formula that is easy to use?
Internal Rate of Return (IRR) is the answer
Technically, IRR is defined as discount rate that leads to net present value as 0.
Where NPV = 0
Practically there is an easy way to calculate this – using the XIRR method in an excel spreadsheet.
If you are checking your LC platform or some other real estate crowd funding platform account monthly, then your account may look something like this laid out by months with cash flowing in and out (lets continue with the above example)
Note that for XIRR function to work, deposited money is NEGATIVE while withdrawl is written as POSITIVE. Please make sure final account balance is the last cell.
There you have it folks – as thought, the returns are NOT 10% but 8.77%
Give it a try on your accounts on lending and real estate investment platforms. You may be surprised by the results.