In private real estate placement offerings each offering memorandum has its own unique metrics. All investments are not cut from the same cloth and there is a bit of a learning curve to get up to speed on different industry terms. We will discuss a few common issuer operating metrics below.
What are Cash-on-Cash Returns?
Another metric for investments is cash-on-cash returns. Simply put, this calculation determines the income on the cash invested. It is relevant to real estate because investors and developers often leverage their own equity with additional layers of financing when making direct real estate investments. The cash-on-cash return is the annual dollar income divided by the total dollar investment.
What are Cap Rates?
Finally, another term frequently used when discussing the purchase and sale of investment property is the capitalization or 'cap' rate. The cap rate is calculated by dividing the net operating income (NOI) by the cost or sale price of a property. For example, if an apartment complex has an annual NOI of $500,000 and sells for $10 million, then the property sold at a cap rate of 5%. Some investors also make the distinction of calculating the 'trailing cap rate,' which is derived by dividing the property's trailing 12-month actual net income rather than any future predictions of NOI.
What is IRR and AAR?
The IRR of a real estate investment is defined as the 'annualized effective compounded return rate.' Some investors might be more familiar with another common term—the Annual Average Return (AAR). Investors typically see the annualized rate of return in mutual funds that report historical returns for say a three-, five- or 10-year period. However, IRR is a measure typically used in real estate, because it takes into account an important factor that AAR does not—the time value of money.
There are two key differences between an IRR and an AAR.
- An IRR factors compounding into the calculation whereas an AAR does not take compounding into consideration.
- An IRR is time-sensitive. For example, the faster the distribution of returns, the higher the IRR will be when all other factors remain constant. AAR is commonly defined as the arithmetic mean of a series of rates of return.
What Are Equity Multiples?
In real estate, equity multiples are used primarily as a measure of the total return paid to an investor. The equity multiple is found by dividing the cumulative distributions from a project by the paid-in capital. The equity multiple differs from the IRR in that it does not take into account the length of the investment period or the time value of money.
Equity multiple = cumulative distributed returns / paid-in capital
How Equity Multiples and IRR Work Together
Equity multiples and IRR are closely intertwined in real estate private equity. A notable difference is that the equity multiple is static, while the IRR is variable. For example, if an investor puts in $100,000 and gets $200,000 back in total return, that is a 2x equity multiple. It has no bearing on how long it took to earn that return. It can be a valuable exercise to overlay an equity multiple with IRR to get a sense of the total return that also accounts for the timing of the payout on that return. The faster an investor gets that return, the higher the IRR. If an investor gets 100% of that return—all $200K in one year, that is a 100% IRR. However, if the investor receives that return in 5 years, the 2x multiple doesn't change, but the IRR drops, perhaps to 20%, depending on the timing of distributions.
Final Thoughts
In the world of real estate investing, no single metric tells the whole story. While metrics like IRR, AAR, cash-on-cash returns, cap rates and equity multiples offer important insights into real estate investments, they are just one part of a comprehensive evaluation process. Investors should consider a wide range of factors about an investment, including strategies, objectives, business plans, market trends, property fundamentals, financing structures, and more.
Learn more about investing in CRE in our updated commercial real estate guide.
