When it comes to investing in multifamily real estate, investors are often presented with a myriad of financial metrics that can be overwhelming. Understanding these return metrics and related terminology is crucial for making informed investment decisions. In this blog, we’ll break down some of the key metrics and terms that investors should be familiar with to evaluate any multifamily real estate opportunities.
1. Cash on Cash Return (CoC): This metric measures the annual cash flow generated by the property as a percentage of the amount of cash invested. It is calculated by dividing the annual net cash generated by the total cash invested in the property.
The formula for calculating CoC is:
Cash on Cash Return = (Net Annual Income / Initial Cash Investment) x 100%
Example: Let’s say you purchase a property for a total cost of $1,000,000. The property generates $10,000/Year in net cash after accounting for all operating and non-operating expenses.
Cash on Cash Return = ($10,000 / $100,000) x 100% = 10%
2. Average Annual Return (AAR): This is a metric used to measure the average annual rate of return on an investment property over a specific period of time. The AAR considers all of the cash flows associated with the property and any capital gains or losses upon the sale of the property.
The formula for calculating the AAR is:
AAR = (Total Return / Investment Period)
AAR % = [(Total Return / Investment Period) / Initial Investment] x 100
Example: If we purchase a property for $200,000 and assume a hold period of 5 years. Assume we also generate $12,000 in cash flow every year for 5 years and sell the property for $240,000 in year 5.
Total Return = ($12,000 + $12,000 + $12,000 + $12,000 + $12,000) + ($240,000 – $200,000) = $100,000
AAR = ($100,000 / 5) = $20,000 per year
AAR (%) = ($20,000 / $200,000) x 100% = 10%
3. Internal Rate of Return (IRR): The internal rate of return is the interest rate that makes the net present value of all cash flows from the investment equal to zero. IRR, unlike AAR, takes into account the timing of cash flows, refinance proceeds, and sale proceeds.
In practical terms, if an investment has higher cash flows in the earlier years of the investment period, the IRR is likely to be higher than if the same cash flows were received later in the investment period, assuming all other factors remain constant. This means that investments with faster payback periods and more significant early returns will typically have higher IRRs, which may make them more appealing to investors.
The formula for calculating the IRR is:
Internal Rate of Return (IRR) = (Future Value ÷ Present Value)^(1 ÷ Number of Periods) – 1
To calculate the IRR, you can use a financial calculator or use the IRR function in Microsoft Excel.
4. Equity Multiple: The equity multiple is a financial metric used in real estate investing to measure the potential total return on an investment property. It helps investors assess how much profit they can expect to make relative to their initial equity investment. In essence, the equity multiple tells you how many times your initial investment you can expect to receive back over the life of the investment. This includes cash flows and any profit at sale.
Example: An equity multiple less than 1.0x means you are getting back less cash than you invested. An equity multiple greater than 1.0x means you are getting back more cash than you invested. For instance, an equity multiple of 2.50x means that for every $100,000 invested into a CRE project, an investor could be expected to get back $250,000.
5. Return on Investment (ROI): ROI is a straightforward metric that calculates the total return on an investment as a percentage of the initial investment. It includes both cash flow and any capital appreciation upon sale.
The formula for calculating the ROI is:
ROI = (Net Profit / Initial Investment) x 100%
Example: If you invest $100,000 and receive $20,000 in profit from a real estate syndication, your ROI would be 20%.
6. Cap Rate (Capitalization Rate): The cap rate is a ratio that represents the property’s annual net operating income (NOI) as a percentage of its market value or acquisition cost. It is often used to compare the relative risk and return of different properties.
The formula for calculating the Cap Rate is:
Cap Rate = Net Operating Income (NOI) / Property Value
Example: If a property generates $25,000 in annual NOI and is valued at $500,000, the cap rate would be 5%.
(For a deeper understanding of this topic please read our blog on Cap Rates)
7. Preferred Returns: Preferred returns are a predetermined, fixed rate of return that is paid to LP investors in a real estate syndication before other investors or the sponsors receive their share of profits. They are typically expressed as a percentage of the investors’ initial capital contributions. Preferred returns are designed to provide a level of safety and predictability to investors, making the investment more attractive by ensuring that they receive a minimum return on their investment.
Example: You decide to invest $100,000 in the syndication, and the syndication agreement specifies a preferred return rate of 8% per year. Let’s assume the property generates $10,000 in net cash flow during the year after covering all expenses. You will receive the first $8000 (8%), and then the remaining $2,000 will be split between you and the sponsor as per the LP/GP split outlined in the Agreement.
It is important to note that preferred returns can vary in structure and complexity. They can be cumulative, meaning that any unpaid preferred returns accrue and must be paid in the future, or they can be non-cumulative. The specific terms and conditions for the preferred returns should be carefully reviewed in the syndication documents, as they can significantly impact the overall return structure for LP investors.
In conclusion, investing in multifamily real estate as a passive investor can be a very rewarding venture. However, evaluating the return metrics of the investment offering is crucial for making informed investment decisions. While each metric provides a unique perspective, the combination of all these metrics offers a holistic view of an investment’s potential. Also, understanding the interplay of these metrics, alongside market conditions and working with the right sponsors that have the operational expertise to execute on the presented business plan, is key to successful passive investing in multifamily syndications.