As with any asset class, real estate investors need uniform ways to evaluate and compare the target (ex ante) and realized (ex poste) returns of real estate investments. Private real estate has historically exhibited low correlation with public markets. Many institutional investors regard private commercial real estate – with its illiquidity and inherent worth – as an opportunity to de-correlate from public markets and reduce exposure to systemic risk at the portfolio level.
Professional commercial real estate investors make use of a handful of return metrics. All are useful, but none are sufficient on their own to determine the relative appeal of a real estate investment. This article breaks down common return metrics in the context of private real estate investment, and their application and limits. Before diving in, note that ex ante return figures are based on assumptions and modeling; return figures are only as good as these assumptions, models, and the team doing the modeling.
This metric (also commonly referred to as the “cash yield” of an investment) can be represented as a simple equation:
Cash on cash return = (Annual Dollar Income) / (Total Dollar Investment)
As such, this return metric provides a clean, quick way of assessing the magnitude of cash distributions throughout the lifetime of the project. Implicit in the formula is that this return metric is an average across every year the project encompasses. For example, our cash-flowing workforce housing multifamily offering in Groton, CT projects to an average annual cash return (or cash-on-cash return) of 10-12%* based on projected net operating income at the property. This calculation excludes the profit earned at reversion, when principal is also typically returned.
As the projected annual distribution schedule for the Groton multifamily investment indicates, distributions to investors are projected to increase over the lifetime of the term as the Sponsor makes operational improvements and increases NOI, culminating in a reversion year where investors are projected to receive a healthy cash return, along with their pro rata share of sale profits and return of principal (we will discuss in more depth how sale proceeds are distributed among the Sponsor, GP and LP investors, during later installments of this series). Excluding the proceeds from sale, EQUITYMULTIPLE investors are projected to receive a 10-12% cash-on-cash return for the entire term of the investment.
Limits of Cash-on-Cash Return
The Cash-on-Cash return metric averages distributions over the ordinary period of operation of the underlying asset. For a given cash-on-cash return value, an asset’s cash flow can vary wildly from month to month and year to year. In some cases, the business plan may call for a period of little or no cash flow prior to stabilization.
Be sure to evaluate the target distribution schedule across the lifetime of the investment.
Our namesake is also one of the core metrics used in evaluating real estate investment opportunities, and perhaps the simplest to employ. The metric is calculated simply by total profit, plus equity invested, divided by equity invested:
Equity Multiple = (Total Profit + Max. Equity Invested) / (Max. Equity Invested)
Returning to our Groton, CT Multifamily example, the equity multiple at the base case projection, for the minimum investment of $10,000 would be calculated as
Equity Multiple = ($8,588 + $10,000) / $10,000 = 1.86x
This could be put in words simply as “your money back, plus 86%”
Limits of Equity Multiple
While the equity multiple provides a nice snapshot of overall profitability of an investment, it does not discount to present value – in other words it does not incorporate the time value of money and account for the duration the investor’s money is tied up – nor does it say anything about the distribution of cash flow throughout the lifetime of the project. Imagine if the same Connecticut multifamily offering instead returned $10,000 in profit, for an equity multiple of 2.00x, but over a 10 year hold. Despite the higher equity multiple, no sane investor would choose this option. Alternatively, imagine that the investment paid the same $8,588 in profit, but in one single payment upon sale at the end of the 5-year term. This option would be less appealing, as the investor would forego the opportunity to reclaim capital and put their money back to work throughout the lifetime of the project.
Internal Rate of Return (IRR)
The internal rate of return (IRR for short) is the most commonly relied-on return metric in equity real estate investment. It is also the most complicated. The internal rate of return is a discount rate that makes the net present value (NPV) of all cash flows from the investment, across time periods, equal to zero.
If you haven’t seen an upper-case sigma since college, do not be alarmed. IRR cannot be calculated analytically, and must instead be computed using software (a simple Excel function can accomplish this). The higher the IRR, the more appealing the investment.
As a discount rate, IRR accounts for the time an investor’s money is tied up in an investment; holding all else constant, the more time periods the investment comprises, the lower the IRR. Since the “time value of money” looms large for active investors, this feature is the main reason IRR is so prevalent in real estate investing. Active investors are keenly aware of liquidity and the time value of money – the “tying up” of dollars in a long-term investment is detrimental, as it precludes using that money for other investments or personal use. Internal rate of return accounts for this.
EquityMultiple frequently offers senior debt or preferred equity investments, wherein investors are entitled to a flat rate of return. IRR is therefore a less meaningful ex poste return metric when evaluating performance. In some cases, though, a variation in expected hold period or distribution schedule may impact the time-weighted return of the investment. With preferred equity investments, the outcome of additional upside may materially impact the overall return of the investment. In either case, IRR may be appropriate to use when retrospectively considering the performance of a debt or preferred equity investment.
For more on how EquityMultiple reports ex poste returns on realized investments, please review our Track Record.
Limits of Internal Rate of Return
The main drawback of IRR is essentially the opposite of the equity multiple’s weakness: while it does incorporate time, it is not the best gauge of an investment’s overall profit potential. A very short project may show an outsized projected IRR despite low projected profit. The second drawback is akin to the equity multiple’s other weakness; the IRR alone also says little about the distribution of cash flow throughout a project.
Consider two common equity investments: one returning all principal and profit only at the end of the term upon sale, and the other returning consistent cash flow throughout. These two vastly different investments could have the same target hold period and an identical IRR objective. Investments that offer stable cash flow are typically preferable, as they entail less risk and offer the opportunity to put capital to work elsewhere sooner.
A Note on Using Return Metrics in Practice
No one return metric should be used in isolation as you evaluate the target or realized returns of an investment. Whether you are looking back at realized returns, or evaluating target return objectives, use all three metrics to arrive at a complete picture of investment performance. Examine how cash flow is expected to occur throughout the investment’s term, the underwriting assumptions, and all attendant risk factors.
Keep in mind that return projections are only as good as the people doing the projecting. As a passive investor, be sure to take a close look at the track record of the GP investor/Sponsor – this is a crucial step in evaluating the return potential and risk of an investment.