Compound annual growth rate (CAGR) is the rate of return (RoR), or the net loss or gain of a commercial real estate investment over a specific period of time, that is needed for the investment to grow from its starting balance to its ending balance.
In other words, the CAGR is the yearly growth rate of an investment over specified time periods during its lifespan assuming profits are reinvested at the end of each period of the investment’s lifespan. The CAGR is one of the most precise ways to determine returns for investment portfolios, individual assets, and any other investment that can fall or rise in value over time.
What Is the Compound Annual Growth Rate (CAGR)?
The Compound Annual Growth Rate (CAGR) is a mathematical equation that lets an investor know what their investment yields on an annually compounded basis. This tells them what funds they have at the end of an investment period.
For instance, let’s say a commercial real estate investor invested $25,000 in a property in 2015. By the end of the year, their investment was worth $75,000, which is a 200% increase. In 2016, the investor lost 50%, dropping their total down to $35,00 at the end of the year.
To find the compound annual growth rate, the investor would use this formula:
CAGR = (BVEV)n1 −1
EV: Ending value
BV: Beginning Value
N: Number of Compounding periods
How to Calculate CAGR
To calculate the CAGR in the aforementioned example, take the nth root of the total return. “N” stands for the number of compounding years or the number of years that the investment was held. In this case, you’d take the square root (since the investment was over a two-year period) of 50% (the total return for the period) and obtain a CAGR of 22.5%.
Pros and Cons of Using CAGR
The CAGR is one of the most accurate methods for calculating historical returns. An investor can also use it to compare the relative performance of their investments, better understand correlation among assets, and use it to estimate expected future returns.
However, the CAGR does not take the investment risk into consideration and assumes a constant growth rate during the investment tenure, unlike imputed equity.
Compound Annual Growth Rate and Financial Ratios
CAGR can be used to analyze the behavior of your investments over a series of years. But it isn’t a complete look at your total assets. Consider supplementing CAGR with accounting and financial ratios like the debt-to-equity ratio and the break-even ratio.