For commercial real estate investors, syndicators and others involved in the field, investment terminology can appear to be an alphabet soup of mysterious acronyms. There are three in particular that are related to the return on real estate investments, and each has its own unique meaning and purpose.
They include CoC, which stands for Cash-on-Cash Return, IRR, which is an abbreviation for Internal Rate of Return, and Average Annual Return, which is self-explanatory. I’ll explore all three, and discuss the differences of each and how they apply when exploring real estate investments.
Cash-on-Cash Return is the simplest way to evaluate the performance of a real estate investment. It utilizes a formula to calculate the return on investment by taking the property’s annual net cash flow and divide by the investment’s down payment, and is expressed as a percentage. One important detail to keep in mind is that Cash-on-Cash Return doesn’t include the property’s appreciation or any principal debt payments. Appreciation is only taken into consideration when it is realized after the property is sold. It also doesn’t include principal debt payments.
Suppose you bought a property and your net cash flow was $5,000, and the cash invested in your property was $50,000. Using that example, your Cash-on-Cash return is 10% ($5,000/$50,000). The net property investment is usually the down payment - which is the property’s cost minus the amount you borrowed.
It’s a simple formula, but it’s critical to know how to calculate cash-on-cash return in order to be a successful investor. Just be sure it’s not the only measure you use to evaluate a potential real estate investment. Take a good look at factors like vacancy rates, operating expenses, debt service and any pre-rental improvements and repairs. All of those numbers will give you a good overview of the potential investment.
Cash-on-cash measures are best when evaluating a property’s first year performance, or when used to project a property’s first year performance that you’re considering buying. Here’s why: after 12 months the actual cash invested that you use in the formula to calculate the ROI will be changing as the loan is paid down, or when property improvements and repairs are made.
The main issue with CoC as a metric, is that it doesn’t take into consideration the time value of money; so if, for instance, you invested $1M in two deals and received $100,000 back (in addition to your initial investment), but in investment #1 you got the money back after 3 years while in investment #2 it took you 10 years to make the same profit – CoC will still be identical, even though it’s clear that investment #1 is better.
As a metric for a potential investment, you’re probably wondering what a “good:” cash-on-cash return would be. The problem is that the experts in the real estate investment field disagree on what constitutes a “good” CoC investment. Some look at a return of 6-8% as “good” while other experts would expect a CoC return of 10% or more. The bottom line is that “good” is subjective and is based on your willingness to take risks.
IRR [Internal Rate of Return]
When looking to analyze potential real estate investments, there are different metrics available. We’ve discussed the CoC, or cash-on-cash measure, but IRR is going to take things up a notch. Learning what IRR is - and isn’t - will help you improve your analytical ability when it comes to making investments in commercial property.
IRR is quite popular as a way to measure investment performance. But popularity notwithstanding, you’ll need to hone in on what the IRR really does. That’s because it’s widely misunderstood, and because of that we’ll start with learning about the common misconceptions so you have a clear understanding of how IRR works.
Don’t be alarmed by the following definition, because this isn’t advanced calculus, but IRR simply put is the percentage rate earned on each dollar invested for each period of time that it’s invested. Others simply call this interest. Whatever you call it, you’re comparing different investments based on their yield.
Another way to look at this is to think of IRR as the rate needed to convert the sum of all future cash flow to equal your initial investment. IRR takes into account the time it took an investor to receive his initial investment (and profit) back. The best (and frankly the most sane) way to calculate IRR is in Excel.
For example: You invest $100,000 in a deal. The property generated cash flow of $40,000 in year 1, and $50,000 in year 2. At the end of year 2, the property is sold and the initial $100,000 is then returned. The total profit is $90,000 ($40,000+$50,000). CoC is 9% ($90,000/$100,000), but since two years have passed, the return percentage is negatively impacted. In this example the IRR is only 6%. The timing of when cash flow is received has a significant and direct impact on the calculated return. In other words, the sooner you receive the cash, the higher the IRR will be. IRR is one powerful metric in helping to choose an investment, but you need to keep in mind that it doesn’t always equal the annual compound rate of return on an initial investment. Why is this important? As stated above, the IRR measures the internal investment amount remaining in an investment for each period it’s invested. But an internal investment can go up or down over the holding period, and IRR doesn’t address what happens to capital that is taken out of the investment. That’s why the IRR doesn’t always measure the return on the initial investment.
When looking at a “good return” you simply want to ensure that your return reflects a sufficient amount based on the risk of your investment. If you’re investing in a stabilized asset your IRR will be lower than if you’re investing in a property in an unproven area or one that requires renovation or repositioning. . In today’s market, many multifamily deals are closed between 11%-13% IRR, while y minimum is 15%, and that’s why most deals don’t work for me today.
AAR [Average Annual Return]
Average annual return, or AAR, is another metric used by investors to look at the overall historical performance of a specific investment. This could include residential or commercial real estate, stocks, bonds and other investment types. It is the average amount that is earned each year over a given period of time. Most investors look at an average annual return in a three, five and ten-year performance. Just be aware that average annual return is not the same as average annual rate of return.
In its most basic mathematical formula, you take the sum of the return rates of your investment over a specific number of years and divide it by the number of years. Let’s say you want to calculate the average annual return over five years; the return in each year was 4%, 5%, 7%, 6% and 8%. Your average annual return would be 6% (30% divided by 5 years).
As an investor looking at a commercial building, for example, you’d want to know the potential investment’s current annual return as compared to its historical return. It’s just one more measure of the investment to consider as part of your due diligence, along with the CoC and the IRR.
Doing Your Homework
Now that you have a basic understanding of CoC, IRR and AAR, let’s take a look at the differences between them. The key difference between CoC return and IRR is time. Let’s say you hold your investment for one year - at that point CoC and IRR are pretty much the same. But if you hold your investment for over a year, IRR will provide a more accurate view.
We’re starting with these because when looking at a syndicator’s deal, these are the two measures you’d want to see. Just be aware that each metric has its limitations. the limits of using internal rate of return is that by itself it isn’t a great measure of an investment’s overall profit potential. And because cash-on-cash return measures are generally taken as an average of the period of operation of the underlying property, the cash flow can vary greatly.
AAR is a historical look at a property’s performance, so it really can’t be compared to CoC or IRR numbers. The historical look is usually a 3-year, 5-year or 10-year analysis, and CoC and IRR are current performance numbers.
The main thing an investor needs to remember is that no single measure will provide the guidance needed to assess an investment property’s potential. You need to use multiple measures to determine the viability of a potential investment, along with the track record of the key investor or syndicator, the area the property is located in and many other factors. Doing due diligence in all of these areas is the only assurance that you have really done your homework before you invest your money. Working with a syndicator who truly understands these metrics is a smart way to go if you don’t have experience with commercial real estate investments. Here’s more on how to find a top syndicator if you don’t currently have one.
As you can see, there are a variety of measurement tools available to evaluate real estate investments before investing your money. Learn the pros and cons of each one, and remember to use more than one metric in your evaluation. That way you’ll have the appropriate information needed to make an informed investment decision.
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About the author
Ellie is the founder of Blue Lake Capital, a real estate company specializes is multifamily investing throughout the United States. She is also the host of a weekly podcast called "That REllie Happened?! Unbelievable Real Estate Stories with Ellie", a podcast that brings the true stories behind the deals, from the most successful real estate investors around the globe. Ellie started her career as a commercial real estate lawyer, leading real estate transactions for one of Israel’s leading development companies. Later, as a property manager for Israel’s largest energy company, she oversaw properties worth over $100,000,000. Additionally, Ellie is an experienced entrepreneur who helped build and scale companies by improving their business operations. She holds a Masters in Law from Bar-Ilan University in Israel and an MBA from MIT Sloan School of Management.