In the previous blog post, we discussed the importance of investing in strong markets and explained how to vet a sponsorship team, but let’s face it, we need to know what a good deal looks like before deploying capital. Investors must first understand how returns are reported and how these metrics fit their personal goals. The reporting of projected returns will look different from your 401k statement; however, don’t let that intimidate you. Knowledge is power!
Let’s begin with a disclaimer. Return projections in syndicated real estate opportunities are not guaranteed returns. If a sponsor claims otherwise, you should immediately clarify this guarantee. The targets displayed in offering materials consist of forward-looking assumptions based on current and historical property and market data and trends.
Cash on Cash Return (CoC)
Cash on cash (CoC) return is a vital metric that reports cash flow distributions relative to the invested capital. In offering materials, it will commonly be advertised as an average CoC over the projected hold time of the asset. As marketing of the opportunity progresses, offerings will often include yearly cash flow scenarios. If a team projects an 8% average CoC, it does not mean you will receive 8% annually. In value-add investing, expect a ramp-up period of cash flow during implementation of the business plan.
Suppose you invest $100,000 into a passive opportunity with a projected 8% CoC average to which the team delivers over a 5-year hold period. Assuming none of your initial capital was returned in a refinance, you would expect total cash flows of $40,000 from this investment.
Refinance events can affect the total amount of cash flow received. For instance, let’s assume a year three refinance of the above deal returns 50% ($50,000) of your capital. This situation may set up higher cash on cash returns since you have less money invested in the deal, but the overall cash flow received could be less.
Preferred Return
Preferred returns, often called a “pref” set up a hurdle that must be achieved, allowing certain classes of investors to get paid before others. For example, if an offering pays a 7% preferred return, the first 7% of the profit is paid to limited partners. When the hurdle is reached, the general and limited partners will begin sharing earnings. Often these returns accrue, meaning if the 7% hurdle is not achieved in a particular year, the short amount is carried to the following year. Investors should verify with the sponsorship team that an accrual is in place. The preferred return is not a guaranteed return; however, it does allow limited partners to be paid a percentage of the profit before general partners participate in profit sharing. Preferred returns between 6-10% are typical in passive offerings.
Average Annualized Return (AAR)
Average Annualized Return (AAR) is the metric used by most other investment vehicles such as individual stocks, mutual funds, or cryptocurrency. This metric measures all returns received from an asset, such as cash flow and equity upon sale, and divides them by the hold time. Use AAR to compare real estate offerings to other investment vehicles. I look for passive opportunities projecting 15% plus annualized returns.
Internal Rate of Return (IRR)
This concept is likely new to novice real estate investors; however, it is crucial to understand as it is often most heavily weighted by experienced investors. Before we get into the details, we first have to mention the time value to money because understanding this theory will make you a better overall investor.
The time value of money states that having cash in your hand to invest today is superior to receiving that same cash in the future? Why, you ask? Capital wants to grow; the sooner it is deployed, the longer duration of time it will have to compound. Money waiting on the sidelines has no avenue for growth. Not only is it not growing, but its purchasing power is likely being eroded by inflation.
Internal rate of return (IRR) quantifies the amount and timing of all distributions received and reports as one metric. These distributions include cash flows, returned capital from a refinance, profits, and retuned capital at disposition (sale). Sponsors often look for the highest IRR scenario when considering a sale, enabling investors to recycle capital quicker. I prefer to see IRRs in the teens, with 15% or greater often being the sweet spot.
Equity Multiple (EM)
Equity Multiple reflects the total return, including all distributions such as cash flow, return of capital, and profit, dividing them by the invested amount. Let’s keep this simple.
- Equity Multiple of 1 = you get your money back with zero return
- Equity multiple < 1 = you lose money
- Equity multiple > 1 you make money. Drop the 1 and move the decimal 2 places to the right. Eg. EM 1.5 = 50% total return
- EM 2.0 = double your investment
One detail to note when looking at equity multiple is the lack of a time factor. For example, an opportunity could achieve an EM of 2.0, meaning a doubling of your investment; however, the AAR and IRR could be suboptimal if it took ten years to achieve.
Conclusion
Every investor has a unique investing thesis. Perhaps a retiree on a fixed income is looking for higher cash on cash or preferred returns. Investors in growth mode may be searching for higher IRR scenarios with refinance events, enabling them to deploy their capital quicker across multiple deals. Many opportunities offer both. The key is to understand what your personal goals are and to take action!