What metrics do you use when analyzing a real estate deal?
There are many ways to look at deals; which deal is best varies with economic conditions, resources and goals of the investors plus you can only buy what the market has to offer which isn’t always what you prefer to buy. Below are two ways to look at real estate investing plus 3 metrics explained (Cap Rate, Cash on Cash, and IRR).
– Opportunity to Generate Cash Flow:
Possible when the spread between the Cap Rate and your cost of funds is sufficient. We bought a nice deal several years ago with a family office as a 50% partner: 5.9 Cap rate over 4% 10-year fixed debt with 3 years of interest only. Nice spread, right? However, when the i/o ended and the mortgage constant got closer to the Cap Rate, the cash flow dropped precipitously and our partner wanted to exit even though the remaining cash flow + principal pay down equaled a solid 8%+ return on equity invested. We were able to get an excellent mid teen IRR (pre-tax!) even though we had to pay close to a couple million in defeasance (pre-payment penalty on loan). Personally, I would’ve held the community, at least till maturity, but you try to keep your partners happy.
– Opportunity to Create Equity:
Often called value add. Is there something to be fixed? Can you fix it? Will fixing generate sufficient rewards? The trouble is true value add is a minority (20%?) of the market yet the majority of the funds (80%?) out there say they are value add investors. Sorting the wheat from the chaff is what makes a good investor. Plus being able to execute once the deal is done.
A measure of unleveraged return on real estate, cap rate is similar to interest rates on bonds. If the current cap rate demanded by the market is 5%, then a real estate investment that returns $100,000 a year in NOI (Net Operating Income i.e. Revenue less Expenses) is worth $20,000,000.
$100,000/5% = $20,000,000 i.e. NOI/Cap Rate = Value
$20,000,000 x 5% = $100,000 i.e. Value x Cap Rate = NOI
Cash on Cash (Equity in Investment/Cash Flow of Investment):
A measure of current (usually LEVERAGED i.e. with debt) return on a community, cash on cash is simply the cash flow of a community divided by the amount of equity the investor has in a community. Since most real estate investments carry debt, cash on cash is also a measure of leveraged return. Cash on Cash return should be higher than the interest rate, the mortgage constant, and the cap rate otherwise negative leverage is occurring which is a bad thing. An investor who has invested $30,000,000 and expects an 8% cash on cash is looking for $2,400,000 a year or $200,000 a month.
Internal rate of return (IRR):
The interest rate at which the net present value (NPV) of all the cash flows (both positive and negative) from a project or investment equal zero. You will see 10 year pro formas (projects of income, expenses and eventual sales price) with projected IRR’s to the 2nd decimal place designed to guide investment. Personally, I’m challenged to come up with a decent financial plan one year out, much less 10 years. Then to project a cap rate on a sale 5, 7 or 10 years out? Smoke and mirrors; nothing but wild guesses dressed up with fancy math! But folks want a number, a sense of certainty…
Issues with IRR:
1. Not a measure of Absolute Return: Big difference in absolute terms between a 20% IRR on $10,000 versus $1,000,000 ($2K v. $200K). Great to make a 20% IRR but on what dollar amount? It’s a lot easier to get eye popping returns on small dollar amounts.
2. VERY Time Sensitive: Invest $1,000,000 – make $100,000. Good? Excellent? So-so? If it took 30 days, 120% IRR. But if it took a year, only 10% IRR.
3. Contains No Measure of Risk: Evaluates outcomes, NOT their probability.
4. Not Designed to Measure Liquidity Costs: Assumes that you can re-invest at same return; i.e. terrific if you can continuously do back to back investments. More realistically, you have to sit on cash in between investments.
5. Pre-Tax Measure of Return: However, what you keep, have to re-invest, is post taxes. This is an issue common to most metrics.
As always, I share what I most want and need to learn. – Nathan S. Collier