In real estate, and other types of investing, it is crucial to understand the rate of return and what it means for the future of your investment.
While all returns are projections, there are several different ways of quoting returns, which can mystify the expected payout and make it difficult to compare investments on an “apples to apples” basis.
Net Versus Gross
First, it is important to understand whether the rate of return quoted is gross or net of fees.
Many investment platforms post a gross, rather than net, projected return on their marketing materials for obvious reasons—it’s a bigger number!
Depending on the fee structure, this number might be one to two percentage points* higher than the the real take-home rate of return. As a result, it pays to ask questions to find out whether the number you’re evaluating is gross or net.
Absolute Versus Annualized Returns
In addition to the net versus gross distinction, there are varying ways to quote returns based on the time over which these returns are realized.
Some investment opportunities are quoted as a “total absolute return” that spans the lifetime of the investment. This is customary for common equity investments.
Other real estate investment opportunities, such as preferred equity, mezzanine debt, and senior debt, are quoted with an “annual return,” or annual percentage rate (APR), which represents the projected return per year over the term of the investment.
You can imagine the difference this makes. Pretend you are evaluating two deals: one that is quoted with a total (absolute) gross projected return of 24% over a five-year period, and one with a 14% gross annual projected return, also over five years.
All else being equal, would you rather receive 14% every year or 24% in total over five years?
Cash Flow and Distribution Schedules
Different investments might also carry different distribution schedules, which should further impact your decision to invest.
Equity investments often provide irregular cash flows and are susceptible to capital calls. Moreover, in ground-up development projects, there are likely to be few if any distributions during the first year or two of the construction phase.
Let’s say there is an investment with a 12% gross annual projected return but no intermediate payments—all of the interest accrues and gets paid out at the end of the investment. If you need cash flow, and can’t afford to have your funds tied up, you might prefer an investment that pays you less over time, but provides a more regular stream of interest payments.
The Bottom Line
The way to choose the best investment for you is to take the time to educate yourself.
Ask questions. Find out how the investment is structured. Is the rate of return quoted gross or net of fees? Is it an annualized number, or does it represent the total return over the life of the investment? How often will investors receive payments?
A savvy investor is one of who unlocks the full potential of passive income and succeeds in building a customized portfolio that fits their needs as a result.