Average Rate of Return

A measure of the profitability of a real estate investment or a type of return metric. The average rate of return is calculated as the total net profit of an investment (total cash inflows minus total cash outflows), divided by the length of the investment, divided by the invested capital. The main drawback of this return metric is that it does not take into account the time value of money.

Average Rate of Return = Total Net Profit ÷ Investment Period ÷ Equity Contributed

Example:

An investor purchases a retail center for $1,000 in cash. The investor holds the center for 10 years, during which the investment earns $100 each year in rental income. At the end of the 10-year period, the investor sells the property for $1,500. To calculate the average rate of return (ARR), follow these steps:

  1. Annual Earnings:
    • The investment earns $100 each year for 10 years.
    • Total earnings over 10 years: $100 × 10 = $1,000
  2. Capital Gain:
    • Initial purchase price: $1,000
    • Sale price after 10 years: $1,500
    • Capital gain from the sale: $1,500 – $1,000 = $500
  3. Total Net Profit:
    • Total annual earnings: $1,000
    • Capital gain: $500
    • Total net profit: $1,000 + $500 = $1,500
  4. Calculate Average Rate of Return (ARR):
    • Total net profit: $1,500
    • Investment period: 10 years
    • Initial investment (equity contributed): $1,000

    Formula:

    ARR = Total Net Profit ÷ Investment Period ÷ Equity Contributed

    Calculation:

    ARR = $1,500 ÷ 10 years ÷ $1,000

  5. Step-by-step Calculation:
    • First, divide the total net profit by the investment period:
      $1,500 ÷ 10 years = $150
    • Then, divide the result by the equity contributed:
      $150 ÷ $1,000 = 0.15 or 15%

Result: The average rate of return for this investment is 15%.


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