The average rate of return is the average annual amount of cash flow generated over the life of an investment. This rate is calculated by aggregating all expected cash flows and dividing by the number of years that the investment is expected to last. For example, an investment in real estate is expected to generate returns of $22,000 in the first year, $32,000 in the second year, and $36,000 in the third year. The average of this amount is $30,000. The initial investment was $300,000, so the average rate of return is 10% (calculated as the $30,000 average return divided by the $300,000 investment).
The key flaw in this calculation is that it does not account for the time value of money. Cash flows in later periods are worth less than cash flows in more recent periods.