Metrics That Matter - Part I
Commercial Real Estate
When analyzing a commercial real estate investment opportunity, there are lots of numbers that help guide investors to determine whether the property projects a return that both meets the investor’s goals and is deemed by the investor to be a risk adjusted return relative to other investments in the market. The following provides a description of several of the top metrics that the experts use to consider whether an investment is worth making. Of note, when presented a prospective opportunity to investors for consideration, some metrics will be denoted as a “Target”, which simply means that the offering includes inputs, such as rents and expenses, that are speculative in nature and will rely upon the execution of a business plan in the future before being realized.
The internal rate of return, or “IRR”, is the measure of an investment’s rate of return and is often called the discounted cash flow rate of return or “effective compounded return rate”.¹ It is the return of a property using a time value snap shot of inflows and outflows of capital over a projected period of time, also called the hold period. To break it down a bit further, consider that the investment is made as an outflow of money at the start, or time zero, and distributions are made by the property as inflows of money to the investors at times projected into the future over the hold period. Finally, upon sale an inflow of money (hopefully a profit if the asset is sold for more than the purchase price, fees and capital improvements).
Using a financial calculator or excel, the underwriter of a project will use these inflows and outflows at projected periods of time to achieve a projected return of the project. Of note, multiple IRRs can be projected by changing the inputs used. And since time is a significant input that impacts the IRR, if nothing else changes but the hold period is shorter than originally projected, the IRR will increase, and if the hold period is lengthened the IRR will decrease, even if there is no actual change to a project’s performance.
The Cash on Cash, or CoC, return is the ratio of annual before-tax cash flow to the total amount of cash invested, expressed as a percentage.² For example, if an investor invests $100,000 into a project and receives a distribution in year 2 of $5,000, then the cash on cash for that year is $5,000 / $100,000, or 5%. When a ‘Target Cash on Cash’ is presented for a particular transaction, it may be shown as the average of cash on cash ratios over the hold period term. For value add transactions, the property is likely to undergo some form of improvements during the early years of a hold period, and therefore may be expected to have lower cash on cash until the work on the property has been completed and rents can be increased.
The Equity Multiple is a multiple that reflects the total cash that an investor has put into an investment to the amount of cash that the investment has generated in full.³ For example, if an investor puts $100,000 into a property and receives $200,000 in total from distributions over the hold period and profit upon sale, this scenario would be reflected as a 2.0X equity multiple because $200,000 returned divided by $100,000 invested equals 2.0. The Equity Multiple differs from the Cash on Cash ratio due to the fact that the Equity Multiple is calculating cash flow and distributions over the entire hold period, whereas the Cash on Cash is only looking at cash flow on an annualized basis.
When looking at the three metrics – IRR, CoC and EM – to determine whether to invest in a particular real estate project, and to compare returns from one project to another, it is also important to review and consider the following factors: the time period the project is projected to be held, the market where the asset is being purchased (more core/metro markets have higher property values that are considered less risky, but may also have lower relative cash flow and therefore projected returns), the scope of work required by the business plan, the cost and terms of the senior debt on the property, the experience of the operator and ability to execute on the business plan, the project’s fees, risk factors that are specific to the project, the exit cap rate used for projecting the property’s target sale price, and the macro and micro economic factors that support the business plan as presented (i.e., projected rent growth, projected job growth, projected income growth, the number of units under construction in the market or submarket that may impact supply).
When underwriting projects, RealtyMogul’s team reviews all relevant and available data before presenting opportunities to investors, and attempts to offer to investors investments that reflect the returns that like projects are also currently projecting in the market.
Call our Investment Representatives today at (877) 781-7062 and learn more.
Interested in learning about more metrics that matter? Click here to read Part II.