Any savvy investor knows that reading a stock summary or private real estate investment offering memorandum comes with 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.
For example, reading the stats on a real estate stock means deciphering measures such as the P/E ratio and EPS (earnings per share). Analyzing direct real estate offerings is a completely different ballgame. Two of the key metrics to understand are targets for The Internal Rate of Return (IRR) is the rate at which each invested dollar is projected to grow for each period it is invested. It differs from other metrics in that it accounts for the concept of the “time value of money”, or the fact that a dollar received and reinvested elsewhere today is worth more than a dollar expected... More (Internal Rate of Return) and cash-on-cash returns.
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 that annualized rate of return in mutual funds that report historical returns for say a three-, five- or 10-year period. However, IRR is a preferred measure for 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.
One example to help put some of these measures in perspective is CrowdStreet’s posting of Timber Oaks Apartments, a multifamily investment opportunity in the Dallas metro area. The series of targeted cash flows for Timber Oaks is both a 22.7% AAR and a 17.8% IRR. The targeted outcome is different because the formulas account for time differently.
As you can see in this series of cash flows, based on a $50,000 investment, we are targeting a total return of $56,726 (total cash-on-cash returns of $17,784 throughout the holding period plus $38,942 of total profits upon sale). Since we are assuming a 5-year holding period, this means we are targeting an AAR to investors of $11,345 ($56,726 / 5) or 22.7% ($11,345 / $50,000). Alternatively, when using the time-sensitive and compounding methodology of an IRR to calculate a return on this same series of cash flows, it yields a 17.8% IRR.
Another important measure for investment opportunities 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 is the use of various financial instruments or borrowed capital to purchase and/or increase the potential return of investment. Assume a buyer puts 20% down on a $5M property. Essentially, they paid $1M to own something worth $5M. Assuming the property appreciates at 5% per year, the sponsor’s net worth would grow to $5,250,000 in a year. Had they... More their own equity with additional layers of financing when making direct real estate investments. The Cash-on-cash return calculates the cash income earned on the cash invested in a property. It’s sometimes also referred to as the cash yield. Cash-on-cash measures the return on the actual cash invested, whereas standard ROI take into account the total return on investment.... More is the annual dollar income divided by the total dollar investment.
Finally, another term frequently used when discussing the purchase and sale of investment property is the capitalization or “cap” rate. The The capitalization, or “cap”, rate is used in commercial real estate to indicate the rate of return that is expected to be generated on a real estate investment property. The calculation is based on the Net Operating Income the property generates divided by the Purchase Price. Lower cap rates (3-5%) generally point to safer / less risky investments and are... More is calculated by dividing the Net operating income (NOI) equals all revenue from the property minus all operating expenses. In addition to rent, a property might generate revenue from parking and/or service fees such as laundry, housecleaning services, pet rent, and more. Operating expenses include the costs of running and maintaining the building and its grounds, including insurance, property management fees, legal fees, utilities, property... More (Net operating income (NOI) equals all revenue from the property minus all operating expenses. In addition to rent, a property might generate revenue from parking and/or service fees such as laundry, housecleaning services, pet rent, and more. Operating expenses include the costs of running and maintaining the building and its grounds, including insurance, property management fees, legal fees, utilities, property... More) 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.
Analyzing different investment metrics can, at times, seem like wading through a thick fog of alphabet soup. The key for crowdfunding investors is to make sure to understand the differences and use the same measures to provide an “apples-to-apples” comparison when considering potential investment opportunities.