Have you ever looked at an offering memorandum and become confused by the industry jargon around cap rates, cash-on-cash returns, and price-per-foot comparisons? Sometimes, the more you try to understand, the more confused you become. In this two-part article, I’m going to cover the primary ways real estate investors value deals and compare returns.
In part one, we discussed replacement cost, sales comparisons and price per square foot. Here are some additional terms to understand:
The capitalization rate, or cap rate, is the rate of return an investment would generate based on the Net Operating Income (NOI) and the Purchase Price (Value). The formula is NOI/Value = Cap Rate. Cap rates can be thought of as a rate of return generated if the property were purchased all cash.
Calculating values using the cap rate is common among real estate investors as a quick and easy way to compare one facility with another when considering investment opportunities. However, there are some limitations to using cap rates. First, cap rates are limited to a one-year return, not multi-year. Second, cap rates don’t consider financing terms which can vary widely depending on the deal, the location, quality, age, etc.
For those reasons, cap rates fall shy of helping investors determine investment value. A deeper analysis is required before making an investment decision.
The cash-on-cash (CoC) return, or cash yield, is the before-tax cash flow of an investment based on the cash invested. The formula is Before-Tax Cashflow/Cash Invested = CoC Return. In other words, before I pay my taxes, what return am I making this year as a percentage of the money I invested? Cash-on-cash answers that question.
There are some drawbacks to using cash-on-cash returns. First, like the cap rate, the cash-on-cash return is an annual return, not multi-year. Also, cash-on-cash return is more difficult to calculate than a cap rate because it uses the cash flow AFTER debt service and BEFORE taxes as one of the inputs.
However, cash-on-cash does consider income, expenses, AND financing, the very things investors are concerned with. That said, it’s an easy-to-understand formula we use when evaluating self-storage opportunities. Finally, something useful!
Internal Rate of Return
If you’ve stuck with me up to this point, you’re a trooper. Now it’s time to put on your thinking cap if you haven’t already because we’re going to talk about the internal rate of return (IRR). Don’t worry, we won’t get into the weeds too much, but if you like details and math, visit www.investopedia.com and search “IRR” to learn more.
The IRR is the discount rate that makes the net present value (NPV) of all cash flows equal to zero. Does your brain hurt already? Stick with me, it gets a little better.
In regular words, think of the IRR as the rate of return needed for an investment to produce the projected future cash flows over the hold period.
In an offering memorandum (OM), you’ll typically see projected cash flows over the hold period, say five years, a sale price at the end of the hold period, and your expected return of capital at the end of the hold period.
For example, let’s say you invest one million dollars in a storage deal. The deal is going to be held for five years and then sold. Over the five years, you expect to receive annual cash flows after paying debt service. At the end of the five years, you expect to receive back your initial investment of one million dollars, plus another one million dollars in profit from the sale of the property. How do you determine your rate of return since the cash flows occur in multiple years and vary widely in amounts? This is where IRR comes in.
IRR considers both the amount of cash flow hitting your bank account and the timing of those cash flows (the year), to predict what your rate of return will be. This is something cap rates and cash-on-cash cannot do because they are one-year calculations, not multi-year.
I’ve left out a lot of information as to HOW the IRR is calculated, which has a lot to do with the time value of money and is beyond the scope of this article. But I hope you understand what the IRR is telling you: It smooths out large and small cash flows over multiple years to provide an average annual return which can then be compared to other investment opportunities.
Because the future is uncertain, some investors balk at the idea of basing investment decisions on IRR projections. However, it’s important for investors to at least consider the future and how property performance can affect the potential returns. Reviewing IRR calculations from sponsors will give you insight into their thought processes and how they underwrite deals.
In summary, IRR considers the income, expenses, financing terms, AND the time value of money, something all investors should be concerned with.
The equity multiple (EM) is a simple return on equity (ROE) calculation. The formula is All Cash Received + Initial Investment Returned/Initial Investment = Equity Multiple. EM is usually expressed as a real number rounded to one or two decimal places, not a percentage. For example, 2.50 not 250%.
EM is an easy-to-use way of determining how your money will grow but does not consider the hold period or time value of money. Would a 2.5 EM over seven years be better than a 2.0 EM over three years? Probably not, because you can take that 2.0 EM and reinvest it and possibly double it again in another few years. Think of the EM as a price per foot metric, but for your money: it’s quick and simple, but doesn’t tell you everything you need to know about an investment opportunity. We calculate the EM for each of our deals, just like we calculate the price per foot, but it’s not the calculation we make decisions on.
Compound Annual Growth Rate
The compound annual growth rate (CAGR) is the rate of return an investment would need to grow from its beginning amount to its ending amount. It sounds like IRR, but with a caveat: the calculation uses the beginning investment amount and the ending cash returned, not the intermediate cash flows over the hold period.
CAGR is useful to calculate your return when you buy and sell shares of stock that don’t pay dividends. If you bought Zoom stock in January 2020, then sold it in January 2022, you might want to know what your return would have been for each of the years you owned your shares. That way, you can compare your annual returns to the annual return of the S&P 500 for 2020 and 2021.
To relate this to real estate, you can use this metric when you invest in a development deal that doesn’t pay cash flows during construction. A CAGR is moderately easy to use and can be calculated by hand. However, don’t confuse it with the IRR. They are not the same thing and we do not calculate the CAGR when evaluating deals.
As investors, we should be focused on investment value, the income, expenses, financing options, and the time value of money when making investment decisions, and not be sidetracked by all the metrics and numbers that can distract investors. The next time you open that offering memorandum, keep the above explanations in mind, and you’ll be better prepared to review the numbers and make an investment decision.