When you invest your hard-earned money in real estate, or any other investment, it is no secret that you want to make more money. In the language of investments, this extra money you make, expressed as a percentage or a ratio, is called a return. In this article we look at some commonly used metrics for measuring returns in commercial real estate: the equity multiple, return on investment, cash on cash return and internal rate of return. We will provide a numerical example on how to calculate them, provide interpretations of the metrics and comment on which one (s) to use and when.
Equity Multiple: If you have invested in real estate before then you were likely presented with the equity multiple by the deal sponsors. If they did not, then ask for it next time. It’s an easy metric to calculate and explain. Basically, it tells you how much you will get for every dollar you invest. To obtain the equity multiple, you simply divide total distributions by total initial investment. For example, if you invest $50,000 in an apartment syndication and you received $100,000 in total distributions (the initial $50,000 investment plus another $50,000) then your equity multiple is 2x, i.e. ($100,000/$50,000). In other words, for every dollar invested, you get back $2. Sounds like a good investment, right? It depends. We will find out at the end of this article.
It is important to note that the equity multiple, which the sponsor will provide at the time of pitching the deal will be an expectation and not a guarantee. The calculations of returns are based on the cash flows that the property is expected to generate. The projected or targeted equity multiple depends on a lot of assumptions and on prevailing and future macro and microeconomic conditions that may be beyond the control of the sponsors. Macroeconomic factors include the fed raising or lowering interest rates, a tool used to control inflation, recessions or the government providing stimulus to help fight a pandemic, for example. On the other hand, microeconomic factors include demand and supply, the economics of labor and the allocation of resources. All of these have an effect on what prices or rents people will pay. However, an experienced team of sponsors should be able put together a robust risk management plan that will help weather the storms that may come along. Holding periods for real estate investments can last a few to many years. Therefore, it is not inconceivable to expect some hitches down the road and plan accordingly. Ask for the risk management plan and how it will be operationalized to protect your investment.
Watch out for sponsors using fancy terms like ex-ante returns (i.e. expected returns, those based on assumptions) or ex-post returns (i.e. actual returns based on the cash flows realized and distributed). When in doubt, ask for clarifications. Other metrics similar to the equity multiple are the return on investment (ROI) and the cash on cash return (C on C).
Return on Investment (ROI): Unlike the equity multiple, the ROI only considers the total money you made over your initial investment and it is given as a percentage while the equity multiple is given as a ratio. In our example above, the ROI is equal to ((100,000 – 50,000)/50,000) *100% = 100%. In high school, we called it percentage change while grownups, who are more concerned about money than the SAT, call it return on investment.
Cash on Cash Return: The cash on cash return is also similar to the equity multiple but it is a periodic metric. Assuming the investor receives cash flow every year, it is calculated by dividing the cash flow for a particular year by the total initial investment. Assuming that the total distribution in our example above were received in equal installments of $10,000 for five years with the initial investment returned in the fifth year, then the cash on cash return for each of the first four years is 20%, ($10,000/$50,000) *100% while the cash on cash return for the fifth year is 120%, ([$50,000 + $10,000]/$50,000 = $60,000/$50,000) *100%.
All of the metrics discussed above give you an idea of how much you make or expect to make from your investment but they don’t tell you anything about how time affects the value of your money. We all know that a dollar today is worth more than a dollar in the future. Remember inflation? In other words, the metrics do not factor in the time value of money. This is where the internal rate of return swoops in to save the day or helps give us a better picture of your investment performance.
Internal Rate of Return: The internal rate of return (IRR) is by definition the discount rate that makes the net present value (NPV) of future cash flows equal to zero. What, how does that help? I agree, you only care about what IRR tells you about your investment. Simply, for investors, the discount rate or IRR is the average annual return you expect to receive from your investment. It’s biggest difference from the metrics discussed earlier is that it factors in the time value of money. As a result, it depends on the holding period of the investment and also the timing of the cash flows. In general, the higher the IRR the more attractive the project or investment is. However, one has to be careful because the IRR is also highly susceptible to manipulation. Later cash flows are discounted heavier than earlier ones. In other words, the longer the holding period, the lower the value of the later cash flows. So, a sponsor can project bigger cash flows early in the holding period by pushing capital improvements down the line, for example. The bigger cash flows coming in early will experience less discounting than later cash flows. Therefore, the project that delays the capital improvements will show a higher IRR and appear to be the best.
So, which metric do you use? In order to do a thorough analysis of the investment, use all of the metrics. Each has something to tell the investor. The equity multiple, ROI, and cash on cash return tell the investor how much cash they will be getting, or expecting to get, annually or at the end of the holding period, but reveal nothing about the time value of money. That is a key weakness given that money loses value as time goes on. Quick note: did you notice that if you know the equity multiple, you can easily tell what the ROI is and vice versa? See formula section for a discussion.
Unlike the equity multiple, ROI and cash on cash, the IRR tells you the average annual return, factoring in the time value of money, but does not tell you how much you are actually getting. It is easy to see that the metrics are complementary and should be used together. However, depending on the investor’s goals, some metrics may garner more attention than the others.
An investor who wants to move on fast and invest in other things will prefer the IRR and take their money early while an investor who wants to delay paying taxes may prefer taking their money later and will pay more attention to the equity multiple and overall distributions. Again, it depends on investor preferences and goals. In conclusion, when considering an investment, please pay careful attention to all the return metrics discussed above.
Formulas
As you can see, throughout the discussion above, the calculation of the IRR is deliberately left out. The formula is a bit complicated and cannot be solved “by hand”. You have to use excel or some financial calculator. So why bother you with the “math”? Knowing how to calculate it using excel, for example, and knowing what it tells you is more important. To calculate IRR in excel and other formulas and examples, see below.
1. Total Distributions = Total Initial Investment + Sum of all distributions during holding
period.
2. 𝐄𝐪𝐮𝐢𝐭𝐲 𝐌𝐮𝐥𝐭𝐢𝐩𝐥𝐞= Total DistributionsTotal Initial Investment (Given as a ratio, e.g. 2x, 3.5x etc.)
3. 𝐑𝐞𝐭𝐮𝐫𝐧 𝐨𝐧 𝐈𝐧𝐯𝐞𝐬𝐭𝐦𝐞𝐧𝐭 (𝐑𝐎𝐈)= (Total Distributions – Total Initial Investment)Total Initial Investment (Given as a percentage)
4. Connection Between Equity Multiple and ROI
𝑅𝑂𝐼= Total DistributionsTotal Initial Investment− Total Initial InvestmentTotal Initial Investment=Equity Multiple−1
ROI=Equity Multiple−1 and Equity Multiple=ROI+1
Example 1: Given an Equity Multiple of 2.5x, what is the ROI?
ROI = 2.5 – 1 = 1.5 but since it is given as a percentage, you multiply by 100% to get an ROI of 1.5 x 100% = 150%
Example 2: Given an ROI of 145%, what is the Equity Multiple?
Since Equity multiple is given as a ratio, first divide by 100% to get the non-percentage equivalent.
Therefore: ROI = 145%/100% = 1.45 and Equity Multiple = 1.45 + 1 = 2.45 or 2.45x
Example 3: If your total initial investment is $50,000 and the sponsor tells you that the target ROI is 145% and the Equity Multiple is 2.45, as is sometimes the case, you can now see that the information is a bit redundant but does not hurt to have. So how much money do you expect to get back?
Using the ROI, you expect to get 145% of $50,000 = 145 x $50,000/100 = $72, 500 over your initial investment.
Using the Equity Multiple, you expect to get 2.45 x $50,000 = $122,500. Recall that this includes your initial investment of $50,000. If you subtract that from $122,500 you get $72,500, which is the same as the ROI. Again, the two metrics tell you how much money you expect to get and knowing one metric tells you the other.
5. 𝐂𝐚𝐬𝐡 𝐨𝐧 𝐜𝐚𝐬𝐡 𝐫𝐞𝐭𝐮𝐫𝐧 = Periodic or yearly cash flow/Total Initial Investment (Given as a percentage).
6. IRR using excel: Arrange all the cash inflows (distributions) and outflows (total initial investment in an excel column). Negate the total initial investment (cash out flow) and then use the IRR function in excel. For example, if your cash flows are in Column A, Rows 1-5 then type =IRR (A1:A5) in any blank cell to get the IRR. You will notice that we also have XIRR in our examples. The IRR function assumes that the cash flows are received at regular time periods and that may not be the case. Therefore, excel has a function that allows the user to include the dates of the cash flows. If the dates that the cash flows are received are in Column B, Rows 1-5 then type =XIRR (A1:A5, B1:B5).
7. In case you are curious to know, the following is the formula for calculating IRR. As noted above, it cannot be calculated “by hand” and will require software or financial calculator, except for trivial and unlikely cases like for a holding period of 1 year.
By definition, the IRR is the discount rate that makes the net present value(NPV) of future cash flows equal to zero.
NPV = Σ𝐶𝑡(1+𝐼𝑅𝑅)𝑡𝑇𝑡=1 – 𝐶0 = 0, where
C0 = Total initial investment.
Ct= Net cash flow in time period t.
t = 1 to the end of the holding period T.
IRR = Internal rate of return.
About the author
Omar, is the Managing Partner of Auxilia Capital Partners, LLC (a New York limited liability company) and a multifamily investor with advanced training in business management and statistics. He manages day-to-day operations of the business.