Real estate investors have several financial metrics to choose from when assessing a potential asset. ARR is one metric that every real estate investor should use when putting together their portfolio.
Explore the benefits and limitations information gained from ARR can give you about your next real estate investment.
What Is ARR in Corporate Finance?
ARR stands for accounting rate of return, a key metric in capital budgeting. Accounting rate of return provides investors with a speedy assessment of an investment’s potential profitability by projecting a forecast for an investment’s performance over a certain period of time.
Using anticipated revenue for a given period, ARR gives investors an idea of how they can expect the fixed asset to generate a return based on the initial investment.
ARR will account for a wide range of revenue streams and cash flow to project an asset’s expected performance. For example, ARR will include non-operating revenue like depreciation expenses in the final assessment for a more precise picture of the asset’s future.
How Do Investors Use ARR?
The information gleaned from ARR helps investors make decisions between their options between multiple investment opportunities. ARR gives investors a streamlined rate of return based on the initial investment. By establishing the final rate of return as a percentage of the initial investment, ARR lets investors know how effectively their money will work on the investment.
For investors assessing a range of opportunities, financial modeling like ARR can help narrow down options to the most lucrative investments. Because ARR is a percentage rate of return based on the initial performance, investors get a sense of how the average investment performs based on their money down.
In effect, ARR can tell investors which investment will do better with their money.
What Is the Formula for ARR?
To find an investment’s ARR, investors need to know its average annual profit and the total initial investment they put down. The accounting rate of return formula is the average annual
net profit divided by the initial investment.
Average annual profit is a speculative calculation based on an investment’s past performance and projected future performance. Finding the annual profit of an investment is a matter of assessing total revenue together with total expenses.
Establishing annual profit over several years determines an average annual profit going forward that investors can reasonably expect. In real estate investments, average annual profit is determined by the difference between a property’s income streams, capital expenditures, and operating expenses.
The initial investment refers to the total money spent on the investment. For real estate investors, the initial investment in property acquisition can be quite high. The sales price of real estate generally trends upwards. Additionally, property acquisition comes with a number of added fees and initial costs from closing and any necessary upgrades or add-ons that were required for closing.
How Do You Calculate ARR?
Understanding the formula for ARR is the first step to finding ARR on your own.
For real estate investors interested in using ARR to assess the valuation of their investments, here’s a standard breakdown of how you calculate ARR:
- Find the average annual profit of the asset. Annual profit is found through the difference between annual revenue and the expenses accumulated by the asset every year. In real estate, revenue may come from rental income earned by a property; expenses might refer to property taxes, repairs, insurance payments, and so on.
- Account for tax break opportunities before finalizing the annual profit. Real estate is well known for its tax advantages. Depreciation and amortization, in particular, can help minimize an asset’s expenses and maximize its profitability.
- For a high-resolution average annual return, consider utilizing performance from previous years in the total average. Finding the average annual profit over a three-year or even total profit from a five-year period can yield a more precise figure for the final ARR calculations.
- Find the initial investment. This may include costs outside the money down on the property itself: legal fees, appraisal fees, insurance payments, etc. Divide the average annual profit by the total initial investment. Multiply the decimal by 100 to convert it to a percentage.
What Is an Example of ARR in Real Estate?
Suppose an investor is considering three properties; each property has a different ARR.
The first property has an initial investment of 300,000 and an annual average profit of 90,000; the second property has an initial investment of 450,000 and an annual average profit of 125,000; the third is 325,000 and 100,000, respectively.
The ARR for these properties would be as follows:
Property 1: 26 percent
Property 2: 28 percent
Property 3: 31 percent
Using ARR, investors can quickly determine that, based on the projected average profits for these properties, the third is the strongest.
Why Is ARR So Helpful in Real Estate?
ARR is a helpful financial metric in many sectors of the financial world, real estate especially. Real estate has high financial thresholds that can make property acquisition a daunting decision.
To invest with confidence in this high-value asset class, investors need all the information they can get to indicate whether an asset will make good on its initial investment.
Because initial investment is such a critical component to the ARR formula, real estate investors motivated by performance based on initial investment can be more confident when assessing prospective properties. ARR is a great start to determine how a high-value asset will earn a return based on its initial investment.
Furthermore, ARR helps investors assess multiple prospective real estate assets to
determine which may best suit their portfolio. The final calculations from ARR make it clear which assets are most likely to make a return over others.
What Are the Limitations of ARR?
While ARR can be a helpful start to assess the quality of potential investments, it does not present a complete picture; ARR has limitations that investors should consider before moving forward based on its final calculations alone.
To start, ARR neglects the time value of money. The present value of money is generally accepted to be greater than the same amount in the future due to the potential of its earning capacity.
Furthermore, ARR does not account for the cash flow timing of the return. An ARR report will tell investors the rate of return over a protracted period of time as a whole but will not specify when the revenue generated begins to net a return. For all an investor knows, the first three years of cash flow may be insufficient in keeping an asset afloat, with sustainable rates of cash flow only kicking in after it’s too late.
ARR is purely speculative. Future performance is merely a projection based on past performance. Investors cannot be certain that an asset will make good on its reported ARR; as economic trends shift year-over-year, an asset’s performance can drastically change.
What Other Financial Metrics Should Real Estate Investors Use?
The limitations of ARR don’t mean real estate investors should disregard its potential outright. When used in concert with other financial metrics, ARR can become a more useful tool to measure prospective assets.
For instance, the required rate of return (RRR) is commonly used in conjunction with ARR; RRR establishes the minimum return investors should opt for for a given risk level.
Here are a few other SAAS metrics real estate investors should know when assessing an asset:
- Return on investment
- Comparable property values
- Useful life
- Salvage value
- Internal rate of return
- Net operating income
- Capital expenditure
- Annual recurring revenue (ARR)
- Monthly recurring revenue (MRR)
- Net income
- Net present value
The Bottom Line: ARR Is a Fundamental Metric for a Real Estate Investing Strategy
Despite its straightforward formula, ARR is a building block of any effective investment strategy. The more financial metrics real estate investors have at their disposal, the deeper their insight into the quality of prospective investments.
After you dial in on the best assets with ARR and other financial metrics, all you need is the financing to make the investments.
