Real Estate Investing: How Do I Calculate My Returns?
While the process of finding a real estate investment is always interesting, you likely have a goal in mind.
You may be aiming to boost your retirement nest egg, save for a second home, or add some diversity to your portfolio. Regardless, exploring an investment’s potential returns is key to evaluating whether it represents a smart move for you.
Debt and Preferred Equity Returns
First, a word about debt and preferred equity investments.
Both debt and preferred equity involved fixed rates of return. With debt, it’s an interest rate on your loan; with preferred equity, it’s a capped rate of return. Both are contractually agreed upon from the moment you invest.
Of course, risks still apply to those types of financing, so returns can’t be guaranteed. But if your investment is performing according to plan, then you know exactly what you’re getting.
Common Equity Returns
When it comes to common equity, calculating returns is a bit more involved.
That’s because common equity return rates are not fixed. Because they participate in profits that remain after project expenses have been paid, common equity investors have the potential to realize significant gains. Those profits can also involve appreciation value of the underlying property.
That said, if profits are weak, investors could stand to see losses as well. That’s because common equity return rates are not fixed.
Two key metrics for common equity investments are the internal rate of return (IRR) and the average cash-on-cash return objectives. Understanding both will give you another way to assess the strength of any investment opportunity, the potential risk of that investment, and what you can expect if the investment performs as planned.
IRR Explained
IRR is the annual rate of earnings on an investment, given as a percentage of the original investment. At the most basic level, it represents a property’s net cash flow and appreciation growth divided by the target hold time.
Digging a little deeper: IRR is a fine-tuned way to calculate returns because it accounts for the time value of money using a discounted cash flow analysis. If you’ve ever calculated compound interest, it’s a bit like that.
Essentially, IRR measures the return rate earned on an investment during a given time frame, assuming that you are reinvesting your expected cash distributions at the same rate of return. In the real world, some income is usually withdrawn from the investment over the course of time—but the IRR still provides a good way to measure apples to apples.
A Quick IRR Example
As an example, let’s say John buys an apricot orchard for $100,000. Four years later, he sells it for $200,000. His IRR would be about 19%. That’s the annual rate at which compound interest must be paid for $100,000 to become $200,000 in four years.
Continuing the example. Imagine that John invests $100,000 in an apricot orchard with an IRR objective of 19% and a target hold of four years. If the investment performs according to plan, he might earn the following over the next four years.
Original investment: $100,000
Year One Returns: $16,000
Year Two Returns: $17,000
Year Three Returns: $18,500
Year Four Returns: $128,000
Total returns: $179,500
Actual (realized) IRR: 19.09%
A few questions seem to jump out here. Why is John earning less in Year One and significantly more in Year Four? Why do payments received in later years seem to “count less” toward IRR than those received earlier?
To answer the first question: the apricot orchard may need a bit of work when John first takes over. He may want to replace a few failing trees or put in a new irrigation system. John’s returns from the first year or two would typically be lower because of these front-loaded expenses. We’re assuming that he sells the property in Year Four.
To answer the second question: Once they were realized, returns from Year One could be reinvested and begin to earn money, themselves. So they are inherently more valuable than the same sum received in Year Four. That’s the time value of money.
A Glimpse of the Infinite
The takeaway from all of this is that there are infinite combinations of distributions that could result a realized IRR of 19%. The important thing is that, when you take into account the time value of money, the average return comes out to 19% over the four-year target hold.
By the same token, there is an infinite number of ways that John's investment could fail to achieve the target IRR of 19%. The orchard could fall victim to a blight, or it could end up being a boom time for apricots. John might sell the orchard after just two years, or the investment could drag on for six.
In other words, the investment could underperform or overperform. The target IRR is just an objective based on the underwritten assumptions of the company that issued it.
Calculating an Accurate IRR Objective
I do want to add that the accuracy of the IRR objective listed for any investment ultimately depends on the accuracy of the underlying assumptions that were used to make it.
Imagine that a given property’s rents don’t increase over time as expected, or the operating expenses creep up more than anticipated. In that case, the ultimate returns realized may end up bearing little resemblance to the IRR objective that was originally developed at the beginning of the project.
The accuracy of the IRR objective ultimately depends on the accuracy of the underlying assumptions that were used to make it.
In developing an IRR objective, a robust returns model will consider factors such as financing expenses and net operating income objectives, as well as weighting them according to how cash inflows and outflows are timed. IRR analysis is also robust in that it allows investors to change the underlying operating or exit assumptions over time.
Cash-on-Cash Explained
Cash-on-Cash return, also sometimes called the "equity dividend yield", is an investor's annual return divided by the total cash they originally invested.
To be more precise, cash-on-cash is determined by taking the before-tax cash flow of a property (net operating income minus debt payments) and dividing it by the initial capital invested.
A Quick Cash-on-Cash Example
For example, let’s say the net operating income (NOI) of a given property is $150,000; the debt service is $50,000; and the amount initially invested is $1 million. In that case:
(NOI minus debt service) / initial investment = Cash-on-Cash
($150,000 - 50,000) / $1,000,000 = 10% cash on cash return
Cash-on-cash figures vary depending on a property’s net operating income and debt service. But typically, they start off small and grow over time.
For this reason, cash-on-cash figures typically vary during the course of an investment’s hold period. At RealtyShares, we generally present cash-on-cash objectives as an average of the distribution objectives for each year during the investment hold period.
What Cash-on-Cash and IRR May Tell Us About a Given Investment
Both cash-on-cash and IRR offer insights into the desirability of an investment, but neither tells the whole story on its own. They work particularly well when viewed together.
This is where things get interesting.
For example, let’s say you’re looking at an investment opportunity that lists a relatively high IRR but a comparatively low cash-on-cash average. In this case, you can assume that the return objectives are primarily based on the property’s expected appreciation.
Investments like this one typically involve more significant renovations or improvements, which hinder a property’s ability to generate cash flow and thus result in low cash-on-cash yields. The ultimate goal is to increase the value of the property, but until a sale, the free cash flow available for distribution to investors may be limited.
In such investments, the returns are weighted toward the “back end” of the investment and are more reliant on successful execution of the business plan.
The Highs and The Lows
Conversely, a high cash-on-cash average with low IRR suggests that little in the way of renovations may be needed for this particular property. The overall returns from the investment will likely be more heavily weighted on the cash it generates from rental income.
Thus any appreciation in the value of such a property would likely align more closely with any price increases experienced by the overall market, since the “value-add” efforts were relatively limited.
What about a high IRR and high cash-on-cash? This is a good hint that the investment is expected to be relatively short-term and may involve significant risk. In these cases, you should carefully consider the duration and the relevant risks of the investment.
Target Hold Time is Equally Important
A high IRR objective may seem desirable, but consider this.
If the investment has a relatively shorter target hold, then you’ll have to figure out what to do after that investment has been completed. Investment opportunities may not be as attractive at that time.
Both cash-on-cash and IRR offer insights into the desirability of an investment, but neither tells the whole story on its own.
For this reason, many investors prefer an investment with a longer hold period objective. That way, they don’t have to deal with such “re-investment risk” anytime soon.
Finally, if both metrics are relatively low, then the opportunity may be less risky than others and could be attractive to you purely for that reason. Or…it could be a dud. You’ll probably want to ask a few questions.
Back to Brass Tacks
What should my IRR be? And my cash-on-cash?
As you may have guessed, there are no “right” answers to these questions. Every real estate project is different, and each has different IRR and cash-on-cash objectives. Which you choose depends on your investing objectives and your appetite for risk.
