Note: this article first appeared as part of EquityMultiple’s learning series.
Real estate is prized for offering downside protection among stocks, bonds, and other assets, and is typically viewed by institutional real estate investors as a key ingredient in a diversified portfolio. Like any other investment, though, real estate investors need uniform ways to evaluate and compare the expected (ex ante) and realized (ex poste) returns of investments within the real estate asset class.
Real estate investments are evaluated based on a set of industry-standard return metrics. While it’s valuable to understand all of them, no one metric serves as a magic bullet when comparing two potential investments; all should be considered in the context of the investor’s strategy and the makeup of their portfolio. This article breaks down the most commonly-used return metrics and how they’re used in practice. Before diving in, it’s worth noting as well that any return projection is only as good as, well, the projection itself; be sure to take a close look at the assumptions and methodologies employed by the party issuing the return projection.
The Equity Multiple
This metric – which is typically only used when evaluating common (or “JV”) real estate equity investments – perhaps the simplest to employ. The projected equity multiple of a real estate investment calculated simply by total profit, plus equity invested, divided by equity invested:
Equity Multiple = (Total Profit + Max. Equity Invested) / (Max. Equity Invested)
For example, for a prior value-add equity investment on the EquityMultiple platform that featured intermittent cash flow over a 5 year term, 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%”
The Practical Limits of the Equity Multiple
While the equity multiple provides a nice high-level view of the overall profit potential of a real estate equity investment, it does not discount to present value – in other words it does not incorporate the time value of money and put negative emphasis on the hold period when the investor’s money is tied up. It also does not indicate anything about the distribution of cash flow throughout the investment. Imagine if that same example investment (with the 1.86x projected equity multiple) 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. On the other hand, consider if the investment was projected to pay the same $8,588 in profit, but in one single lump sum payment upon sale at the end of the 5-year hold period. Any rational investor would find this option less appealing, as it would mean foregoing the opportunity to reclaim capital and put money back to work elsewhere during those 5 years.
Cash-on-cash Return
Also commonly referred to as the “cash yield” of an investment, this metric can be represented as a simple equation:
Cash on cash return = (Annual Dollar Income) / (Total Dollar Investment)
This ratio provides a quick way of assessing the magnitude of cash distributions throughout the lifetime of the project. Often times yield-minded investors will weigh this metric heavily when deciding between a cash-flowing equity investment and a fixed-rate vehicle (like a bond or debt-based real estate investment). The calculation is an average across every year the investment encompasses. Returning to the Connecticut multifamily offering considered above, the average annual cash return (or cash-on-cash return) is projected at 10-12% based on net operating income at the property. This calculation excludes the profit earned upon sale, when principal is also typically returned.
As the projected annual distribution schedule for this example investment shows, distributions to investors are projected to increase over the lifetime of the term as the General Partner (the real estate firm managing the project) makes operational improvements and increases net operating income, culminating in a sale year where investors are projected to receive a healthy cash return, along with their pro rata share of sale profits and return of principal. Excluding the sale proceeds, investors in this multifamily investment are projected to receive a 10-12% cash-on-cash return over the entire lifetime of the investment.
Practical Limits of Cash-on-Cash Return
Cash on Cash return is an average across each period of the investment term. As such, yearly, quarterly, or monthly cash flow of the can vary wildly, so investors are advised to closely examine the distribution schedule. The biggest shortcoming with this metric, of course, is that it ignores the sale (or refinance) profits at the end of the investment, which often account for a large proportion of the overall profitability of a real estate equity investment.
The Internal Rate of Return (IRR)
The IRR (internal rate of return) is probably the most commonly cited return metric in equity real estate investing. Unfortunately, it’s also the most difficult to understand and calculate. The IRR is a discount rate that makes the net present value (NPV) of all cash flow throughout the lifetime of an investment equal to zero.
The calculation can be presented as the following, with time periods stretching on infinitely until all distribution periods of the investment are accounted for.
Rolled into a cleaner expression, where CF represents cashflow, and I represents the initial capital contribution:
If you haven’t seen an upper-case sigma since your college calculus class, don’t be intimidated. IRR can’t be calculated analytically, and so must be computed using software (Excel can do this in a heartbeat). The higher the IRR, the more appealing the investment. IRR is also employed in corporate finance, with firms often setting a floor IRR below which they will not invest (in equipment, facilities, certifications, etc.), thus it is a useful concept to understand.
Unlike the equity multiple or cash-on-cash return, the IRR incorporates the “time value of money”; holding all else constant, the more time periods the investment comprises, the lower the IRR. Active investors are very sensitive to liquidity and the time value of money – IRR is used so frequently because it accounts for the detrimental effect of having money tied up in long-term investments,
Practical Limits of Internal Rate of Return
The main drawback is basically the converse of the equity multiple: while IRR does factor in the time value of money, the IRR less descriptive with respect to an investment’s overall profitability. A very short-term investment may show a large projected IRR despite low projected profit. The second drawback is similar to the equity multiple’s other weakness; the IRR alone says little about the distribution of cash flow throughout a project. Two equity investments with the same duration could have an identical IRR, with one yielding consistent cash flow throughout, and the other returning all principal and profit only at the end of the term upon sale. In that case, the preferable investment would depend on the investor’s preferences regarding liquidity vs. upside.
A Note on the Use of Return Metrics in Practice
No single return metric should be used in isolation when evaluating an equity investment. All three are useful to get a high-level view, but shrewd investors should take a close look at how cash flow is distributed throughout the investment’s term, the pro forma and modeling used in projecting returns, and all attendant risk factors.
Again, projected return metrics are only as good as the people doing the projecting. As a passive investor, the track record of the GP investor (or Sponsor) – will often be the best guide as far as the risk/return profile of an investment.
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