How to Measure the Net Income Return on Investment?

One thing almost all investors have in common is a desire to know the answer to the question, “How much will I make on my investment?” Put another way, investors want to know what the return on their invested dollars will be, or what their return on investment (ROI) will be. The ROI performance measurement can be applied to measure the effectiveness of all types of assets and is especially useful in real estate. The ROI measurement captures the relationship between net income and invested capital, cash flow and invested capital, and the asset’s total return and invested capital.

The first of these measurements, net income return on investment, captures the relationship between net income and invested capital. This is helpful to financial managers who focus primarily on the traditional income statement. Net income is derived by subtracting all items that are classified as expenses for reporting purposes from gross revenues. Net income is calculated both before and after taxes. It gets a little tricky in that whenever a payment is applied to a mortgage, not all of the payment is treated as an expense. For example, the interest, taxes, and insurance portion of a payment are treated as expenses. The principal portion of the payment, however, is treated as a balance sheet item and has no effect on the income statement. When a payment is applied to principal, two things happen. First, cash is reduced, and second, the loan balance is reduced. The balance sheet remains precisely in balance, as one asset is used to reduce a liability by an equivalent amount.

CASH RETURN ON INVESTMENT

The second performance measurement is referred to as the cash return on investment, also known as the cash-on-cash return. It is the ratio between the remaining cash after debt service and invested capital, also known as owner’s equity. This ratio differs from the net income ROI in that it excludes all non-cash items, such as depreciation expense, and includes the non-income portion of loan payments that are made to principal loan balances. As a general rule, investors tend to focus more on this performance measurement than they do on the net income ROI measurement since it represents the cash return on their investment.

The cash ROI performance measurement is calculated as follows:

TOTAL RETURN ON INVESTMENT

The third performance measurement is referred to as the total return on investment. The total return on investment is similar to the cash ROI with one important distinction—it accounts for that portion of return that is not cash, namely, the reduction in principal. In other words, it takes into account the portion of the loan that is reduced each period by the payments that are applied to the remaining loan balance, or the principal portion of the loan payment. The total ROI is the ratio between the remaining cash after debt service plus principal payments and invested capital. The total ROI is calculated as follows:

Total ROI =  emaining cash after debt service + principal reduction / cash investment

The total ROI performance ratio does exactly as its name implies. It provides a measurement of the total return of an investor’s capital by capturing both the cash and non-cash portions of the return. The noncash portion is similar to making a house payment amortized over a period of years. The value is there in the form of a build-up of equity and a decrease in the liability, or mortgage, as the loan balance is reduced a little at a time over several years. The gain is realized in the form of cash at the time of sale. The total ROI can be calculated as both before-tax and after-tax performance measurements.