Returns Metrics that Matter When Underwriting a Potential Real Estate Investment

Over the past few months I’ve shared various checklists to help you avoid bad deals and sift out the quality deals and quality operators. One of the critical aspects to evaluating a deal is understanding what the investment return metrics mean for your investment, running return sensitivities, and assessing if the return is commensurate with the level of risk you’re comfortable taking on.

There are a few key metrics which investors should be familiar with including cap rates, cash-on-cash return, equity multiple, and the internal rate of return. For the sake of this post, let’s assume that you’re making a $100k investment into a value-add apartment property that has a projected 10-year hold period and is located in a growing neighborhood in Brooklyn.

*I want to thank Bruce Kirsch from REFM for contributing to the definitions of each metric.

Capitalization Rates (Cap Rates)
The cap rate is the yield on cost expressed as a % and is calculated as the [Annual Adjusted NOI / Purchase Price]. The assumed exit cap rate is a key metric to sensitize, as aggressive exit cap rates (especially on short hold period deals) can greatly impact projected investor returns (IRR and Multiple).

Given the projected long-term hold period of the investment (10 yrs.), the IRR and multiple are not highly sensitive to movements in the exit cap rate. Predicting the exit cap 10 years out is like picking your NCAA bracket – basically a shot in the dark. However, since the returns are relatively insensitive to the exit cap, investors should feel comfortable as long as the Sponsor is making a conservative assumption based on the quality of the property and market i.e. cap rates for apartments in Brooklyn are historically 4% – 6%. Relative insensitivity to exit cap rates is one of the qualities I look for in a deal.

Cash-on-Cash Return (ConC)
Cash-on-cash return is expressed as a % and calculated by taking the [Levered Cash Flow / Cumulative Equity Invested to date]. Sponsors will typically quote the year 1 ConC return and average ConC return over the hold period.

The year 1 8.0% cash-on-cash projection means as an investor you’ll receive an 8% distribution on your invested equity (8% of $100k = $8k). That $8k distribution factors into your equity multiple and IRR. It’s important to note the “Net Cash-on-Cash to Investors” reflects projected net distributions to investors after taking into account asset management fee and promote due to the Sponsor.  Cash-on-cash returns are typically calculated on remaining unreturned equity so if the Sponsor returns 50% of investor equity through a refinance, your future projected cash-on-cash returns are calculated on the $50k of remaining unreturned equity.

I look for deals with strong ConC returns out of the gate and over the hold period because even if cap rates blow out, you still get significant equity returned to you over the hold period.

Stabilized Return-on-Cost
The return-on-cost is expressed as a % and is calculated as the net cash flow (before debt service) divided by the total deal basis (acquisition price + closing costs + renovations costs).

While most professionals tend to quote the cap rate, the return-on-cost is more relevant since it takes into account all expenses below NOI (TI’s, leasing costs, recurring replacements) and is calculated off the total basis, not the purchase price.

The stabilized ROC reflects the yield after the business plan has been executed. The Stabilized ROC should be a 200-300 bps premium to prevailing market cap rates and signifies the value that has been added to the investment.

Multiple on Equity (Multiple)
Multiple on Equity aka Equity Multiple aka Return on Equity aka Multiple on Invested Capital = [Net levered cash flow / Total equity invested] + 1. The multiple can be measured on an unlevered or levered basis (the latter only if debt financing is used in the transaction). This metric shows investors the projected cumulative dollars you will receive on an investment as measured after exit. The easiest way to think about Multiple is “how many times you get your capital back.” An equity multiple of 3.8x on a $100k investment means an investor will get $380k (which includes the initial $100k investment) back through combined cash flow, refinance proceeds, and sale proceeds over the projected hold period.

Internal Rate of Return (IRR)
The IRR is by nature an ANNUALIZED rate of return, expressed as a percentage.

The IRR is a bit more of a complex metric as it assumes positive cash flows are reinvested in the transaction and earn the IRR (i.e., if IRR is 10%, positive cash flows to equity are compounded at 10%).

A few important aspects of the IRR include:

• If the investment spans only 12 months, the IRR is the same as the overall return on that cash investment (i.e., “what you made”)
• IRR starts out infinitely negative…
• It becomes less and less negative as capital is being returned…
• It becomes 0% at the point of all capital being returned…
• Then it becomes positive and becomes incrementally greater with each additional dollar of positive levered cash flow generated

The projected 18% IRR takes into account your initial $100k outlay on day 0, the annual cash flows you receive over the 10-year hold, and finally the lump payment at the end of the investment due to the sale. A high-teens IRR is a solid return for a light value-add deal in a quality market.