How To Measure Returns in Real Estate
Real estate, moreso than most industries, has a unique jargon. The depth of the lexicon presents itself in a complex set of return metrics. Each metric gives different insight into the project, and knowing how to measure returns is crucial to evaluating deals on an apples-to-apples basis. Let's analyze what each metric means, and how each metric relates to and builds off of the other metrics, to better understand how to analyze a deal.
The most basic measure of the return on a deal is the capitalization rate, or the famous cap rate. cap rate is the annual amount you earn on an annual basis per dollar invested in a property prior to the effects of debt or leverage. It is easily calculated by dividing the annual net income (income minus expenses) by the purchase price of the property.
The capitalization rate is a good tool for comparing intrinsic property returns without regard to leverage. The reciprocal of the cap rate would be the payback period on the initial investment in years. While most brokers do not account for transaction costs in calculation of the cap rate, a prudent investor will include these costs in the calculation. The cap rate is a point in time metric and does not incorporate returns from capital appreciation or loan amortization.
When comparing two similar properties, the property with the higher cap rate, all else being equal, is the better deal. Each market and property type will have its own average cap rate. The cap rate is a good metric for comparing properties which are similar. However, expect a property in better condition or a better location to have a lower cap rate than a similar property in the same market but in worse condition or in a worse location.
Cap rates vary over time, so even if your income remains constant, but market cap rates increase, your property may decline in value.
Cash on Cash
The cash-on-cash return is defined as the cash flow (net income less loan payments) divided by the cash equity investment in the property. This metric tells you how many dollars of cash you will generate per dollar invested each year. While in an unlevered transaction the cash on cash will be the cap rate, in a typical transaction, the leverage will increase the return in percent terms, while decreasing the actual dollar value of the return. Cash on cash does not incorporate returns from amortization or capital appreciation.
Cash on cash is highly contingent on financing terms. That means that cash on cash tells you the effect of financing on the cap rate. The ability to secure a lower interest rate or higher amortization, while not necessarily generating a higher outright return, may leave you with more cash in your pocket in the short term.
Like the cash on cash, the leveraged return expresses the income generated by the property per dollar invested. However, unlike the cash on cash, the leveraged return includes the income generated by the paying down the mortgage. While this additional component of the return can't be spent, the fact that you owe less money on the property means that in the event of a sale or refinance, you can convert the increased equity into cash.
The leveraged return is calculated by adding the annual amortization back to the cash flow, and then dividing it by the cash equity invested in the property. In deals where the amortization term is short, in other words, where the loan is paid back quickly, the cash on cash fails to include the gain in equity attained by repaying the loan. The leveraged return incorporates that benefit. However, the benefit obtained by paying down a mortgage is not realized by the investor until it is monetized in either a sale or a refinance.
Return on Equity
The return on equity captures the leveraged return plus the benefits of capital appreciation, or the increase in the value of the property in a given year. However, projecting capital appreciation is a difficult task. The primary drivers of capital appreciation are increases in income or market cap rate compression. Income may be increased through prudent property management or through market forces increasing rents. Cap rate compression is only caused by macroeconomic factors pertaining to supply and demand in the overall market. In a case where a property has been managed ineffectively, and where active and prudent management is the driver of increases in value, capital appreciation may be the largest component of the return. However, like amortization, in order to monetize capital appreciation, a property has to be sold or refinanced.
Internal Rate of Return
The internal rate of return (IRR) is defined as the discount rate required to set the net present value of cash flows at zero. Simply put, that is the annualized return per dollar invested over a period of time. One of the assumptions that the IRR incorporates is that cash flows are invested at the rate of the IRR. The benefit of the IRR is that it provides an accurate annualized return on a cash basis incorporating the timing of refinances or sales. However, it is based on the assumption that cash flows can be reinvested at the same return as the initial investment, which is not normally the case.
Modified Internal Rate of Return
The modified internal rate of return, or the MIRR addresses the fact that future cash flows may not be reinvested at the same return as the initial investment. The MIRR is the rate at which the net present value of cash flows is zero with the assumption that cash flows are reinvested at a specific rate. The MIRR is the best all-around metric as it captures both cash and non-cash returns generated by a property, while using a reasonable assumption for the returns generated by interim cash flows. However, when a property disposition is via refinance as opposed a sale, the MIRR will not capture the value of the residual equity in the property.
Multiple on Invested Capital (Equity Multiple)
The multiple on invested capital (MOIC) is calculated as the dollars returned per dollar invested in a property throughout the entire investment cycle. This multiple is calculated by summing all cash returns on a property from investment though its sale, divided by the original cash equity investment in that property. However, since this return is not annualized, it can easily be manipulated by simply holding a property for a longer period of time. Similarly, since this multiple is predicated on a sale of the property, it requires the projection of a sale price years down the road. Making such projections is incredibility challenging if not impossible in some scenarios.
Of the greatest benefits of real estate investment are the multiple tax shields. Income may be offset in large part by depreciation, and capital gains may be deferred indefinitely by means of a like kind exchange. Tax-adjusted returns are subjective and depend on the marginal tax rate of the investor. Therefore these returns are best presented in a table representing the marginal tax rates across the various tax brackets.
Each of the above metrics can be calculated on a tax adjusted basis in a few steps. The first step is to separate out the taxable and non-taxable components of the return. The non-taxable component is typically the portion of the return shielded by depreciation. Then, the non-taxable return is divided by one minus the marginal tax rate of the investor. This return is then added back to the taxable component of the return and used in the calculation of your return metric.
While, there are more metrics of return which are not covered by this post, these are the most common measures of return. Knowing which measure matters most to you will help you select not only the best deals on a relative basis, but the deals that align best with your investment style and horizon.