Rates of Return: Who’s counting what?
Many of you may remember the Beardstown ladies, a 14-member investment club from Beardstown, Illinois, who wrote books about how their common sense investing style made them amazing returns (see an old Time article on the subject). It turns out their published 23.4% returns were actually 9.1% after an accounting firm audited their records!
Better yet, what about those cable shows called something like “Flip that house” where people claimed ten’s or hundreds of thousands of dollars in gains.
Why aren’t people like us making that kind of money?!
I think there are many good take-aways from these examples but here are two: 1. Don’t trust rates of return people brag about; and 2. Most people don’t know how to calculate their actual rate of return.
Let’s take a hypothetical house flipper who buys a run-down home for $200k, fixes it up with $60k over three months, then lists and sells the place in 90 days for $360k. Sounds like an easy $100k doesn’t it? You might say that’s a 38% return ($100k profit / $260k investment), but that’s not the entire picture.
Lets assume they put 20% down, get a great interest only mortgage rate pegged at 5%, pay closing costs of 7%, and pay cash for the upgrades. Lets do the math and look at the cash flows:
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In Jan, they pay $40k cash down payment, $20k house upgrades and interest of $667 ($160k loan * 5% / 12 months).
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In Feb, they pay $20k house upgrades and interest of $667.
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In Mar, they pay $20k house upgrades and interest of $667.
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In Apr, they list the home for sale and pay the interest of $667.
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In May, they pay the interest of $667.
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In Jun, they sell the home for $360k, payoff the $200k mortgage, pay closing costs of $25k, and interest of $667.
That’s a rate of return of 6.18% (IRR), and if they did the same project for the next six months their annual rate of return is a decent 12.35%. A far cry from the 38% above however!
