IRR, Equity Multiple, Cash Return | Common Real Estate Return Metrics

October 26, 2020

This article examines the practicalities and limitations of three common real estate return metrics: cash-on-cash return, equity multiple, and internal rate of return, or IRR.

One or multiple of these return metrics may be useful as you do your own diligence. After all, EquityMultiple’s investment offerings span the capital stack and a range of return profiles.

As with any asset class, real estate investors need uniform ways to compare target and realized returns. Private real estate has historically exhibited low correlation with public markets. Many institutional investors regard private commercial real estate – with its illiquidity and inherent worth – as an opportunity to de-correlate from public markets and reduce portfolio risk. 

Professional commercial real estate investors make use of a handful of return metrics. All are useful, but none are sufficient on their own to determine the relative appeal of a real estate investment. This article breaks down common return metrics in the context of private real estate investment, and their application and limitations. Before diving in, note that target return figures are based on assumptions and modeling; return figures are only as good as these assumptions, models, and the team doing the modeling.

Cash-on-Cash Return

This metric (also commonly referred to as the “cash yield” of an investment) can be represented as a simple equation:

cash-on-cash return formula

As such, this return metric provides a quick way to assess the magnitude of cash distributions throughout a project’s lifetime. Note: this return metric is an average across every year the project encompasses. For example, our cash-flowing Class B multifamily offering in Groton, CT targeted an average annual cash-on-cash return of 10-12%* based on the sponsor’s net operating income at the property. This calculation excludes the profit earned at reversion, when principal is also typically returned.  

In this case, distributions to investors are projected to increase over the lifetime of the term. The Sponsor plans to make operational improvements and increase NOI, culminating in a reversion year. At that time, investors can potentially receive a healthy cash return, along with their share of sale profits and return of principal. Excluding the sale proceeds, the investment targeted a 10-12% cash-on-cash return for the entire term of the investment for EQUITYMULTIPLE investors.

Limits of Cash-on-Cash Return

The Cash-on-Cash return metric averages distributions over the underlying asset’s ordinary period of operation. Notably, an asset’s cash flow can vary wildly from month to month and year to year. In some cases, the business plan may call for a period of little or no cash flow prior to stabilization (typical in a value-add or opportunistic strategy).

Be sure to evaluate the target distribution schedule across the lifetime of the investment.

Equity Multiple

Our namesake is also one of the core metrics investors use to evaluate real estate opportunities, and perhaps the easiest to employ. To calculate this metric, just take total profit, plus equity invested, then divide by equity invested:

equity multiple formula

Returning to our Groton, CT Multifamily example, you would calculate the target equity multiple for the minimum investment of $10,000 as:

Equity Multiple = ($8,588 + $10,000) / $10,000 = 1.86x

Simply put, this equals “your money back, plus 86%.”

Limits of Equity Multiple

While the equity multiple provides a nice snapshot of an investment’s overall profitability, it does not discount to present value. In other words, it does not account for how long the investor’s money is tied up, nor does it say anything about the distribution of cash flow throughout a project’s lifetime. Imagine if the same Connecticut multifamily offering instead returned $10,000 in profit, for an equity multiple of 2.00x, but over a 10-year hold. Despite the higher equity multiple, most investors would find  this option much less appealing. Alternatively, imagine that the investment paid the same $8,588 in profit, but in one single payment upon sale at the end of the 5-year term. This option would be less appealing, as the investor would forego the opportunity to reclaim capital and put their money back to work throughout the lifetime of the project.

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Internal Rate of Return (IRR)

The internal rate of return (IRR for short) is the return metric most investors rely on for equity real estate investments. It is also the most complicated. The internal rate of return is a discount rate that makes the net present value (NPV) of all cash flows from the investment, across time periods, equal to zero.

The calculation can be presented as the following, with time periods stretching on without limit until all time periods of the investment are accounted for.

Internal Rate of Return (IRR) function

Rolled into a cleaner expression, where CF represents cash flow, and I represents the initial capital contribution:
NPV and IRR function

If you haven’t seen an upper-case sigma since college, do not despair. IRR cannot be calculated analytically, and must instead be computed using software (a simple Excel function can accomplish this). The higher the IRR, the more appealing the investment.

IRR in Debt & Preferred Equity Investments

As a discount rate, IRR accounts for the time an investor’s money is tied up in an investment; holding all else constant, the more time periods the investment comprises, the lower the IRR. The “time value of money” looms large for active investors, which is the main reason IRR is so prevalent in real estate investing. Active investors are keenly aware of liquidity and the time value of money. The “tying up” of dollars in a long-term investment is detrimental, as it precludes using that money for other investments or personal use. Internal rate of return accounts for this.

EquityMultiple frequently offers senior debt or preferred equity investments, wherein investors receive a flat rate of return. IRR is a less meaningful realized return metric when evaluating performance of these investment types. In some cases, though, a variation in expected hold period or distribution schedule may impact the time-weighted return of the investment. With preferred equity investments, the outcome of additional upside may materially impact the overall return of the investment. In either case, IRR may be appropriate to use when retrospectively considering the performance of a debt or preferred equity investment.

For more on how EquityMultiple reports returns on realized investments, please review our Track Record. For a more in-depth look at IRR and its practical limitations, please review this article.

Limits of Internal Rate of Return

The main drawback of IRR is essentially the opposite of the equity multiple’s weakness. While it does incorporate time, it is not the best gauge of an investment’s overall profit potential. A very short project may show an outsized projected IRR despite low projected profit. The second drawback is akin to the equity multiple’s other weakness; the IRR alone also says little about the distribution of cash flow throughout a project.

Consider two common equity investments: one returning all principal and profit only at the end of the term upon sale, and the other returning consistent cash flow throughout. These two vastly different real estate investments could have the same target hold period and an identical IRR objective. Investments that offer stable cash flow are typically preferable, as they entail less risk and offer the opportunity to put capital to work elsewhere sooner.    

A Note on Using Cash-on-Cash Return, Equity Multiple, and IRR in Real Estate

No one return metric should be used in isolation as you evaluate the target or realized returns of an investment. Whether you are looking back at realized returns, or evaluating target return objectives, use all three metrics to arrive at a complete picture of investment performance. Examine how cash flow is expected to occur throughout the investment’s term, the underwriting assumptions, and all attendant risk factors.

Keep in mind that return projections are only as good as the people doing the projecting. As a passive investor, be sure to take a close look at the track record of the GP investor/Sponsor – this is a crucial step in evaluating the return potential and risk of an investment.

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