ROI vs. ROT
ROT, or Return on Time, isn’t something you come across often in the financial world, but once you start to learn the craft of investing in real estate, and start to possess the skill of creating income, on demand, outside of a job, this calculation becomes one of the most important when analyzing deals.
Return on Investment is how much money you get back for your total monetary investment (Your Profit / Your Dollars Invested = Your ROI). The goal is to, at a very minimum, beat the average return you can get by investing in a typical index fund (which is the only real totally passive investment out there). Over the long haul different funds have produced different returns, but just for argument sake lets say the average is 8% over time.
That means you would be foolish to put in one ounce of work (or one minute of time) if you are not highly confident that you will get a return higher than 8%. You would be much better off just clicking a button and putting your money in an index fund and carrying on with the rest of your life.
You invest in real estate because you fully plan to beat an 8% return, and if done right, you can beat it by a lot!
The higher above 8% the ROI is, the more it makes sense to spend time on that activity or deal. The Holy Grail is the deal that takes almost none of your time, but still returns a very high ROI. This is typically where all the competition is. Everyone wants the easy paint and carpet renovation, on a ten year old house, in a great neighborhood, being sold at a deep discount.
Amazingly though, most people don’t calculate ROT when deciding whether to purchase a deal.
Rather, they just compare the ROI’s (I was one of them when I first started investing). “Let’s see, I could buy this total gut rehab, 100 year old, 3 unit property, in the inner-city, and convert it to a huge, high end home and make a 30% ROI… or I could buy this cookie cutter, 30 year old home, in the suburbs, that just requires surface level updates and only make 15% ROI… I think I’ll buy big one).
A year and a half later, after firing several contractors, huge building department delays, penalties on my short term financing, picky high end buyers backing out, and burning through double my projected rehab budget, I finally complete the big sexy high end project, and realize I’m barely breaking even and have experienced an incredible amount of stress (not that this exact situation happened to me… more than once… I’m a slow learner)
It took a few of these painful experiences to realize that I possessed the skills to have easily rehabbed six of the 15% ROI deals in the suburbs, with much less stress, in the time it took me to complete the one big deal that never seemed to hit my projected numbers.
Even if the big sexy project hit my projected numbers, I would have still been way ahead doing six of the smaller lower projected ROI deals (and kept a lot more sanity). It’s all about the opportunity cost.
How You Can Use ROT
Because most people are afraid that the deal in front of them is the only deal they are going to get, or because they run their finances so tight they “have” to get a deal going right away to hopefully make payroll, they don’t calculate ROT.
Calculating how much return for every hour you will spend on a particular deal is really the calculation of how much money you are losing by not doing something more profitable, or in other words, it determines the most profitable way you can spend your time.
For me this comes from forcing value (through renovation on properties in high rent areas) on deals that will produce the least amount of friction throughout the investment period.
The bigger you can grow your reserves (this comes by spending less than you make) and the more confidence you develop in your ability to successfully execute deals (this comes from educating yourself), the easier it will be to effectively calculate ROT and avoid the landmines that suck time and life out of you.
You will be stunned by how much your your profit margin increases and your anxiety decreases just by not doing low ROT deals.
One quick disclaimer: this is a powerful tool to help you understand how to get the biggest return from you time, however, this DOES NOT, mean that you should optimize your life to only do things that make you the biggest pile of cash. If you do that you will have a big pile of cash and no friends and an otherwise empty life (and soul).
On the contrary, this gives you the ability to optimize your life for meaningful endeavors, while knowing that the window you set aside for working on investing is bringing you the biggest return possible, so you can enjoy the rest of the time stress free.
In the beginning you might have to optimize more for money in order to start building toward financial freedom, and then you can thoughtfully and intentionally ratchet back, which is why you started this journey in the first place.