- Written by Mike Hesse
Gross Rent Multipliers, Cash on Cash, Capitalization Rates, Equity Return Rates, Internal Rates of Returns, Financial Management Rates of Return - we use them all. Is this investment better than that investment? What is the maximum price I should pay? The investment may be a good one, but does it satisfy my individual goals? Where do I begin?
If we are looking at apartment investments, the Gross Rent Multiplier (GRM) is an OK place to begin. It does allow us to compare gross incomes to values - but that's all it does. It doesn't look at any other relevant factors: income, expenses, debt retirement, depreciation, etc.
Cash on Cash lets us measure how much return we are getting on our investment - but only in terms of cash flow and only in terms of our original investment. It ignores equity growth.
Capitalization Rates (Cap Rates) are swell if we want to look at our Net Operating Income (NOI) in relationship to Value; a key ratio to be sure, but does it allow us to forecast future profits? Certainly not. Cap Rates are only a snapshot of the investment at the time of purchase.
The Equity Return Rate (ERR) is helpful because it keeps us in touch with our deflating returns as our equity inflates, but does it tell me if this is the investment for me? Hardly.
The Internal Rate of Return (IRR) and the Financial Management Rate of Return (FMRR) both have their dutiful and immensely helpful place in assisting us in getting a handle on the return of our investment, the return on our investment, the current and future effects of expenses, financing, inflation, etc. Very impressive, to be sure, but I want to know if I should buy this apartment building or that retail center. I want to know if, with my individual financial demands on my particular financial assets and capabilities, I would be better off buying this self-storage facility or that office building.
I want to be able to compare, based upon my set of assumptions and projections, which purchase would be the best for me, not for Dan or Brewster but for me. I want to know that regardless of the choices presented to me, which investment will satisfy my particular parameters. What will get me to retirement on time, will meet my immediate financial obligations, will carry me through this depression, that recession, this inflationary
bubble, and that deflationary tar pit. In short, I want to know what rate I need to achieve my goals irrespective of the particular investment.
The answer is my creation, the "Your Rate". I want to personalize the rate to fit you. We could call it the Jones Rate, or the Wagner Rate or the Rumsfeld Rate. You put your last name in front of Rate, and there you have it. This rate of return that you must achieve in order to get you where you want to go by the time you need to get there. Let's build one as an example.
The procedure for calculating Your Rate is simple enough. For example, let's use Roger Davis's financial situation and goals. Roger just turned fifty and decided it was time to get serious about having money for retirement at 65. For Roger that means having an annual income equal to $100,000 today. Roger has saved $200,000 to use as seed money and he and his wife have determined that they can invest an additional $10,000 the first year and increase their yearly investment by 10% every year. (For the sake of brevity and clarity, in this example we will ignore the equity the Davis' have in their home, the IRAs that they have been more or less attentive to the past ten years and the money they expect to inherit from their parents.)
Simplified Steps for Roger
To Calculate His "Davis Rate"
Step 1: The first step is to determine the annual income needed at retirement.
a. Age at Retirement 65
Less Age now - 50
Investment Years 15
In the T-bar which follows in item 1c, this total becomes the years.