Good returns are the hope of every investor, but no investment can guarantee a profit. Even though multifamily investments are considered to be a great addition to a portfolio, nothing can be certain. If you want to find a profitable investment, you need all the facts.
While every investment touts a steady ROI, you need to discern for yourself whether you think it’s likely or not. Part of your due diligence as an investor is to look at the investment from all sides, including a multitude of investment metrics.
The most important for multifamily investments are cash-on-cash returns, internal rate of return, average annual return, capitalization rates, and equity multiples.
Cash-on-Cash Return (CoC)
While the cash-on-cash return is sometimes used interchangeably with ROI, they’re actually measuring returns in 2 distinct ways. The CoC metric shows you the returns based on the amount of cash invested rather than on the total investment. It’s mainly used in leveraged real estate investments.
This shows you how much cash profit you stand to make from only the money you’ve invested. It cuts through the noise and allows you to see a basic estimation of your actual cash returns from real estate investments (pre-tax).
This metric helps to specifically communicate the returns from your cash, which is going to make it easier to compare deals directly.
Internal Rate of Return (IRR)
Internal rate of return is a capital risk metric that helps you directly compare investments in completely different assets based on the initial capital investment and projected returns. If you’re weighing multiple investment options, especially in deals that will involve debt, IRR is going to simplify the comparison process.
When you see the IRR of a project, that number tells you the estimated rate of returns the project will generate over a certain period. IRR calculations are done using a net present value (NPV) of 0, meaning future projected cash flows are compared using their value today. Money is more valuable today than tomorrow, so the IRR helps you get a more realistic view of potential returns.
Ideally, the IRR should outweigh the cost of capital. While a higher IRR usually means a higher potential return, this metric should never be used in isolation. Use the IRR to help you identify the potential returns based on projections, but keep in mind that it doesn’t reflect risks, capital costs, or other tangible costs involved in an investment. It also doesn’t give you a real dollar figure, which makes it a bit more difficult to conceptualize if you’re trying to understand the real expected returns.
The easiest way to calculate the IRR of a project is to use an IRR calculator (Excel can also be used to calculate IRR).
Average Annual Return (AAR)
Every investment calculates returns, but simple annual returns aren’t always sufficient to judge the performance of an asset. If you’re looking to invest in a commercial real estate asset already in operation, looking at the average annual returns gives you a better idea of how it holds up in the market.
Returns can vary greatly from year to year. Even if an asset makes a loss one year, it may make up for it with gains from other years. By looking at the average annual return, you’ll get a clearer picture of the actual performance of an asset, which you can compare to other assets more realistically.
Capitalization Rates (Cap Rates)
Cap rates measure the expected return on an asset based on the income that’s expected to be generated in comparison to the value of the asset itself. This is a metric specific to real estate, as opposed to IRR or CoC. The cap rate is calculated from net operating income (NOI), which considers all the property’s income and most of the expenses not related to capital.
When you’re looking at CRE assets, cap rates are mostly a surface-level metric to give you a quick point of comparison. They vary widely between markets and asset classes, so you can’t judge the prospect of a specific asset based solely on the cap rate.
What a cap rate does help you with is risk analysis and giving a general impression of a real estate investment. If cap rates in an area are higher, it may indicate a higher risk in the area. Low cap rates can point to safer investments, with the trade-off being lower returns. The other thing cap rates can show is if a specific property stands out from similar properties. This can indicate that you need to look closely to find out why the cap rate is either lower or higher than it should be.
Equity Multiple
With an equity multiple, you’ll see a quick measurement of how much an investment has returned overall. An equity multiple can be calculated knowing only the total profit and invested cash amount. It’s displayed as a ratio, with ratios above one, meaning the investment has profited and those below one, meaning it has had losses.
Equity multiple looks a lot like cash-on-cash returns and IRR to the untrained eye, but there are a few important differences. While cash-on-cash returns show you how much money can be made from your actual cash invested and IRR shows you the present value of your future investment returns, equity multiple gives a broad picture of the expected returns from your cash investment and the value of the asset itself.
Whenever you’re considering a multifamily investment, you should look at all of these metrics and others to determine the potential of the investment. Each metric shows a unique perspective on a CRE asset, so you should pay attention to each to get the full picture.
