Understanding Different Investment Return Metrics
When comparing different investment opportunities in the commercial real estate space there are numerous metrics used to capture the performance of a given asset. Each metric seeks to highlight a different perspective of the return provided and it is therefore useful to have a high-level understanding of the primary metrics used.
Average Annual Return (AAR)
The ARR is the most relatable return metric for the new multifamily investor to understand. It equates to the returns shown on a stock market investment and is simply the average return of your money per year across a given period. It is useful when comparing a real estate investment to a stock market investment to compare the returns between the two choices.
Internal Rate of Return (IRR)
The IRR is the most useful return metric used in multifamily investing, unfortunately it is also the most difficult to understand. The reason for this is that the IRR accounts for the time value of money by assuming a discount rate that will make the net present value (NPV) of all cash flow across the time periods equal to 0.The calculation is iterative and therefore must be calculated by a computer function such as the one within excel. The power behind the IRR metric is that it shows you not just how much return you will receive for an investment, but also when you will receive those returns. Therefore, when comparing two investments that have overall equal returns but different COC returns, the investment with a higher COC return will have a higher IRR since the returns are being provided to the investor sooner rather than later from the profit of the sale. represent the cash flow for a given period in the equation below and represents the initial investment.
Cash on Cash Return (COC)
Cash on cash return is the average cash distribution per year divided by the initial capital invested. The amount of cash returned each year in a syndication will typically vary some as the business plan is executed and the property is brought to its peak performance. For example, there may be a period of no cash distributions immediately after the acquisition of a property as the major Capex projects are completed. It is therefore important to look not only at the COC return but also the distribution plan.
Equity Multiple (EM)
The equity multiple is a metric that quantifies the overall return on a given amount of capital invested. It is useful when comparing investment opportunities as it shows how much your money will grow in total during the life of the investment. The weakness to this metric is that it does not consider the time value of money. In other words, an investment could be holding your money for 3 years with a 2.0 EM or for 5 years with a 2.0 EM so it’s important to identify the investment timeline when you are reviewing this metric.
There are many important considerations when evaluating a multifamily deal and we make it our mission to careful vet each of these items. If you would like to learn more about passively investing in multifamily, please check out our free ebook "Achieving Financial Freedom Through Multifamily Investing."