#103 Should You Choose The Deal With The Higher Advertised Rate Of Return

Foreign. Welcome to the Passive Income MD Podcast, where we talk about creating your ideal life through multiple streams of income. I'm your host, Peter Kim. If you enjoy hearing about this stuff, make sure to hit subscribe so I can bring it to you every week. Now let's get on with the show. Hey, everyone. Hope you're having a great weekend today. I'm gonna be talking about something that I come across all the time. I don't know if you ever looked at a couple deals, maybe you have them side by side. One advertises a higher rate of return and the other one advertises a little bit lower. And you're trying to decide between the two investments. Maybe they seem the same to you. And what do most of us do? I'm guessing most of us just go ahead and pick the one that has a higher advertised return. I don't know. This is the way I thought about it originally. Was that okay, maybe even if they don't meet their projection. Exactly. There's more wiggle room there. And maybe even if they do a little bit less, they'll still be higher than the other one. So I don't know if that's been you and you've ever done that, but I've definitely been guilty of that. But when we're going to talk about it today, I'm going to just go ahead and tell you the spoiler alert right now. I'm going to jump right to the punchline. Do not choose one investment over another simply because it advertises a higher rate of return. Again, I've been guilty of it. I've done it in the past. In fact, it's gotten me in trouble, you know, and again, I would look at two real estate investments side by side. One might have an internal rate of return, irr. We've talked about some of these metrics in the past. Maybe one shows an IRR of 12%. Another one might show an IRR of like 24%. And I remember thinking, oh, yeah, if the 24% even does half as well as they predicted, then worst case, it'll still match the 12% deal. And I made a decision based on that. However, I've learned that this way of thinking, this method, I don't know if anybody else does it, is wrong for really two huge reasons. And we're gonna talk about both of these. Number one, it's risk. And then number two, assumptions and manipulation. So before we get into those and before we get into that, let's review a couple of definitions just to make sure we're all on the same page. There are two main types of returns that you'll usually see advertised in any sort of real estate deal that you might see. One is called the irr, or internal rate of return. And the second one's called the EM, or the equity multiple. Just to go over these really quickly, irr, if you remember, it's a return on investment calculation that takes into account not only how much you get back, but when you get it back. So it accounts for the time value of money. So the idea is that money's going to be worth less in the future than it is now. And you guys all probably understand that now, because inflation is all in the news today, that your dollar in your pocket is just not gonna be able to, you know, have as much power in the future, at least buying power and purchasing power. So if money that's tied up in investment and it's just sitting there, it could have been used to invest somewhere else in the meantime. So the irr, that metric takes in all of this stuff about time, takes it into account. Now, equity multiple is another return on investment calculation. And there's some other variables that it takes into account. The equity multiple of an investment, it's the cumulative distributive return. So all the money that you've gotten back over the whole entire life of the investment, and you divide that by how much you've been paid in terms of capital. So in other words, it's a total amount returned to you over the life investment divided by the amount that you initially invested. So it's just a straight calculation. Again, doesn't really take into account the time or when you get those distributions. It just takes into account those whole big numbers. So ideally, when you're assessing a potential investment, you want to use both of these metrics. They tell you a couple different things and help you to know what to expect. And it might matter which one you're more interested in, because it might matter what your goals are. And ultimately that'll help you make an investment decision. Which one might be better for you, depending on which return metric makes most sense. But again, you should not base it solely on these numbers and it can lead to trouble. We'll talk about that in a moment. Now, I want to talk about this concept of risk real quick. Many of you are saving money in an online savings account might offer you an interest rate pretty low, right? Maybe 1%, maybe higher, who knows? While certain other investments, they might offer you something like doubling your money in 12 months or that sort of Thing. Now, who wouldn't want to get a huge return, like 100% return in a short period of time? Now, why are these things different? Why do some investments advertise higher rates of return like that? I mean, the reason is really simple. And it has to do with a little something called risk. Now, risk can be summed up with this one simple question. What are the chances that the expected return will become reality? Well, when it comes to receiving interest from the bank, it's pretty much as close to having complete certainty as you can get. You know, you're going to get that 1% every single month. Now, on the flip side, little risk means little reward. And I think we see that and it makes sense now when it comes to some other investments like angel investing. You know, for those who are wondering what angel investing is, we talked about it, but that's when you invest in a startup and a company and maybe you hope that it becomes the next Google or Facebook, the potential for success is far lower. So the rate of return reflects that in those cases. Some people have talked about getting a 10x return, 20x1000x return because. But again, the risk is extremely high. Cause what are the chances you're gonna pick the right one and you know, the potential is there, but the risk and the return are correlated. So to account for this concept, you might hear something called risk adjusted return. This is another return metric that you should utilize. You'll find the best example of risk adjusted return, I think in a casino. I went to Vegas recently. And returns are based on your odds. Yes, they're tipped in the casino's favor slightly, but. But the returns are really proportional to the odds or risk, depending on which game you're looking at. In real life, though, it's not quite so linear. The reason why so many people like investing in the real estate market is that it's not totally efficient, it's not perfect, and therefore can be unpredictable. And so you can find opportunities, especially with real estate investments, that might have a lower return but slightly higher risk than you would expect. Or you might find ones where there's a higher return and a lower risk all within the same market. Now, the key is to identify where the scales are tipping. Which one are you looking at? And this can really only be determined and assessed through performing deep due diligence. But the bottom line is this. The higher the advertised rate of return likely, the more risk is involved and associated with the deal. Well, that's what you should probably initially assume and then look for ways why the deal might make sense. So when you look at what's called the pro forma or deck or investment proposal, offering memorandum, whatever it is, the executive summary, when you see that deal and they put it in this nice package for you, whatever it's called, you're going to be presented with those metrics. Now, if you're like me in the early days of investing or like myself, you're likely to focus solely on the return. Again, looking at those two metrics, equity multiple and the internal rate of return, they will tell you what to expect, or at least what the operator sponsor is telling you to expect when investing your capital. And they do a much better job when you actually use those two metrics together. What I mean by that is, you know, this equity multiple concept, it's easier to understand, I think, than the irr. So let's start here real quick. You know, when you use the equity multiple metric, returns are defined in terms of what you started with and how much you got back. For example, should you expect to get back, you know, one and a half times your money or double your money in what period of time, you still have to consider how long the project is, because two times, you know, double your money in four to five years sounds awesome, but double your money over 10 years and 15 years and 20 years, it's just not quite as good. So that's why equity multiple alone, when you look at that metric, is not good enough to give you the entire picture. And that's why this whole concept of internal rate of return that comes into play, that takes into account the time value of money, I believe that all cash flow matters. And then the timing of those payouts, when it enters your and hits your bank account, it's equally important. That's why I think IRR is probably the best metric used to compare different investments. Because, as you know, in these real estate investments, especially the ones that we talk about in passive, the passive ones, the returns aren't very smooth, and you're gonna get a little bit cashflow upfront, maybe the cashflow grows, you're gonna get some boluses of cash, whether there's a refi or big sort of capital event, this kind of thing. And then ultimately, at the end of the deal, you usually get a big chunk of change when the property sells. So again, most people look at this IRR metric and then they just go ahead and invest based on the highest one they see when comparing a couple different investments. However, what I found over time and what I've learned, and we talk about all the time, in our communities and courses. And the IRR can be easily manipulated if you just change some of the assumptions that they're using to create that. And those big assumptions are when you're going to get your money back, how that cash flow goes, if there's a refinance option right at year two, three, four, five, if you just change those, the timing of returns slightly, it changes the IRR and it can change that dramatically. I've shown examples of this in numbers and charts. But, but your IRR can swing even 5, 10% depending on when you predict or actually assume that you know, refi events will come back to you and when they decide to sell. The one thing you can be guaranteed of is that the projections won't be exactly like they are exactly by the end of the deal. The timing will be different. They'll either underperform or they'll overperform. And your hope is that your chances are, and when you've done all your due diligence, the probabilities are that they've been conservative in their underwriting. And the chances are if they're going to end up on one side, most likely they're going to end up outperforming. Now what's my experience been in this situation? Without bringing up too many painful details from the past, I've invested in quote unquote, safe deals that promise 12% returns, where I've received closer to 18 to 20% returns and that's been amazing. But I've also invested in deals where I expected a 22% returns and, and literally lost money on it. And so to spell it out, I have received negative returns before. Hopefully that's been on a very, very small bit of deals. And that was on the early days before I knew how to do a lot of the due diligence. So yes, advertised returns, that's just one part of the equation. Please do not pick a deal based on just advertised returns. You have to learn who's the one running the deal, who are the sponsors that are running the business plan and ultimately are the ones that gonna be in control of this whole deal. How are they creating their numbers? How are they making their assumptions? Do they tend to be conservative? Do you tend to be a little bit aggressive? What does their track record look like? Maybe even ask them what have you predicted in the past and what have you ultimately gotten for your investors on these deals? There are so many different variables out there that they try to predict for but are actually impossible to predict. What, what's the market going to be like in three to five years. There are predictions and all sorts of analytics that might help you, but there are a lot of things out there in this world that we could just cannot predict. So everything must work together in a way. When you look at all these things that fits your personal investment goals and not just based on these predicted numbers out there. I like to invest with multiple sponsors to see how they operate. I have tried a whole number of sponsors to see what they look like in terms of their reporting, in terms of their projections, in terms of their underwriting. How close are they to the mark? Do they tend to be conservative? Do they tend to be aggressive? These are all kind of things that you should look for to see. You know, if you can look at these numbers and actually begin to trust them. Once I've done that kind of due diligence and I can see how well true returns match up with their predictive returns, then I can make a truly informed decision about what I think the best investment will be. Especially if you have two side by side. Hope this was helpful. Hope this is what you're doing or you're working towards understanding the due diligence and making sure you make good investment decisions. Let us know how we can support you. Have an awesome week. Let's talk again soon. Thanks. Enjoy the show. Let me know by dropping a review in the podcast app you're listening to us in. And if you haven't already, make sure to hit subscribe. Are you part of our community yet? Join thousands of physicians who are also on this journey to creating their ideal lives through multiple streams of income. You can join us on our Facebook group Passive Income Docs and you can always learn more at our website passiveincomemd.com thanks again for allowing me to be a part of your journey. See you next time.