When you are deciding on a real estate investment there are a few main financial measures that you will want to determine if the investment is right for you. This is independent of deciding on the market and the team (if investing in multifamily) which you should do first. Once you are ready to analyze the financial metrics, the main levers you want to focus on are the IRR, CoC, and Equity Multiple. I wanted to write this article to explain the merits of all three and how you can use each to choose opportunities.
Cash on Cash Return (CoC)
The CoC return for an investment is a simple return metric to show your return based on your amount invested. For example: If you invest $100,000 and cash flow $10,000, your CoC return is 10% (which is pretty good). CoC return represents the relationship between cash flow and the initial equity investment. In syndications, it is calculated by taking the cash flow after operating expenses and debt service, divided by the initial equity investment. This can be broken down by the total project or on a percentage basis for each investor based on their specific investment.
The drawback is that CoC return does not account for the time value of money and can be skewed in the case of a refinance. For instance, if cash flow stays steady at 7% over a 5 year hold period each year, with average inflation of around 2%, that return begins to lower over time. However, if in underwriting you account for both inflation and natural appreciation this metric should remain fairly accurate.
Furthermore, because CoC return is based on the initial amount invested, when you refinance and return that initial capital, it makes the CoC return look artificially high. This is where you would want to rely more on average annual return which accounts for the changes in cash flow and the IRR metric which accounts for the cash inflows and outflows over time.
This metric stands for the Internal Rate of Return, which is defined as the discount rate that makes the net present value equal to zero. This metric represents the asset’s projected annual growth rate by isolating the effect of compound interest when the hold period of the investment is greater than one year.
IRR takes the time value of money into account, whereas the CoC return does not. For any investment held longer than a year, this is the metric you want to rely on more for your total return on investment. IRR uses initial equity investment, the cash flows for each year, and the final projected sales proceed in the final year to project the overall rate of return. It is a complex formula to break down, but you can use the IRR() formula in excel to calculate it for the investment.
Where CoC and IRR give you rates of return, equity multiple gives you an idea of what your initial investment will turn into over the hold period. For example, a 2x equity multiple means that you will double your money during the hold period. The higher the equity multiple and the lower the hold time to produce it (all things equal) equates to a better return.
Keep in mind that historically, one can usually double their money in the stock market every 10 years. So generally, you want to see a 2x equity multiple in a real estate investment before 10 years. Otherwise, you could “set it and forget it” in an index fund that tracks the market.
Generally, in a 3-7 year hold period in a commercial multifamily deal, you could expect to see a 1.4-2x equity multiple. I think that the first two indicators are a better gauge of the performance and equity multiple gives you a good baseline to compare to other investment opportunities.
Wrapping it Up
To reiterate, these metrics are only projections. You should not base your entire investment decision on these values. You want to look deeper into the inputs to these values, the business plan, and the team running the investment. If all of that checks out, then you should feel comfortable investing if the returns metrics fit your investment goals. Be wary of high projected returns based on foolish underwriting. I suggest you review the underwriting and ensure it is conservative so that your capital is intelligently allocated to solid investments.