Return Metrics - What to Look For
Updated: Dec 1, 2022
If you're a passive investor or thinking about being a passive investor, you have been exposed to many different metrics regarding a real estate investment. There are tons of metrics out there measuring the performance of a deal. Each metric measures a specific part of the deal, and all metrics are important, however, there are a few critical metrics that evaluate the quality of the deal as a whole. These can easily be lost in a complex spreadsheet, therefore, compiled below are details on the most important metrics to evaluate as a passive investor and what they mean.
Cash on Cash (CoC)
Cash on Cash measures the cash flow generated compared to the amount of capital invested. Cash on Cash is usually measured on an annual basis. For example on an annual basis, if $100,000 is invested and the property generated $10,000 in profit that year, it would be a 10% CoC return. If the next year the property generated $120,000 in profit, it would be a 12% CoC. The CoC can be found in the yearly projections or the summary. An investment should have a CoC that is at minimum the amount of the preferred return so that the distributions can be made. For example, if an investment is offering an 8% preferred return, the CoC each year must be at least 8% for the full distributions to be made.
Equity Multiple (EM)
The Equity multiple is the rate of return based on the total net profit and equity investment. The EM measures how much profit is made compared to the initial investment. For example, if $100,000 was invested, and the EM is 2.0x, the investor will receive a total of $200,000 ($100,000 initial investment x 2.0). Another example, if the EM is 1.75x, the investor will receive $175,000 ($100,000 x 1.75). The EM can be found in the summary where details of the entire project are outlined. An average EM is around 1.75x in current market conditions.
A preferred return is the threshold return that limited partners are offered before the general partners receive payment. This means that the investor's return is paid before the general partners are paid. Therefore, there is an alignment of interest. When a preferred return is offered, the general partners are confident that the asset will perform to expectations. A preferred return is stated in the PPM. A preferred return is very common but not always offered on multifamily syndications. If a preferred return is not offered, there is likely a different incentive offered or a reason based on the business plan. The most common preferred return is between 7-8%.
The Cap Rate is the rate of return based on the income the property is expected to generate. The cap rate does not factor in debt. In other words, the cap rate is the rate of return that would be expected if the property was purchased in cash. The cap rate depends on current market values. Cap rates are often localized and are a comparative source for the current market value. For example, if a property is trading at a 6% cap rate and the NOI (net operating income) is $100,000, the current market value is $1,666,666. Say the demand is very high and supply is low, and therefore the value of the property increases to $2,000,000. this would mean the cap rate is now 5%. In this case, the market is accepting a lower return because the demand is high, and the supply is low. If the property is purchased for $2,000,000 in cash, the investor would expect to receive a 5% return annually.
The cap rate can be found on the summary page. The cap rate changes depending on the income generated. Therefore, if the property income increases and or the expenses decrease, the cap rate will increase as well (increasing the rate of return). The cap rate is usually highlighted at purchase and sale.
Debt Service Coverage Ratio (DCSR)
The Debt Service Coverage Ratio is the ratio of cash flow compared to the debt service. The DCSR measures a property's ability to pay its debt. For example, if a property is generating $150,000/yr in net operating income (NOI) and the debt service is $125,000/yr, the DCSR is 1.25 ($150,000/$125,000).
A long-term loan on a multifamily property usually requires a minimum DCSR of 1.2. The DSCR is located on the summary page where there are details on the expected debt terms/payments. Based on lending criteria, but depending on the business plan, the DCSR should be 1.2 or more at purchase.
Internal Rate of Return (IRR)
The Internal Rate of Return is the total return of a project that accounts for the time value of money. In other words, the IRR accounts for the time that the money is being used.
The IRR is found on the return summary. The projected IRR is calculated at purchase and is based on future income (cash flow, sales proceeds, principal paydown), therefore any change in these figures can have a large impact on the actual IRR. Investments are projected to earn an IRR of between 13-14%.
Let's check out a full example:
123 Main St
Preferred Return: 8%
Purchase Price $2,000,000
Number of Units: 20
Cap Rate: 5.7%
-Decrease expenses with RUBS
-Improve exterior landscaping
Disposition Price: $3,131,00
Cap Rate: 6%
Net Proceeds: $1,485,000
The example deal above illustrates the execution of the business plan and the key metrics to look at before and afterward. If one of the metrics seems too low, it's a good idea to ask how the team intends to achieve the projected returns. Each deal will have a different business plan that will affect the metrics, however, an LP should understand what each metric means and what an average value is.