Any savvy investor knows that reading a stock summary or private real estate investment offering memorandum comes with its own unique metrics. All investments are not cut from the same cloth and there is a bit of a learning curve to get up to speed on different industry terms.
For example, reading the stats on a real estate stock means deciphering measures such as the P/E ratio and EPS (earnings per share). Analyzing direct real estate offerings is a completely different ballgame. Two of the key metrics to understand are targets for IRR (Internal Rate of Return) and cash-on-cash returns.
The IRR of a real estate investment is defined as the “annualized effective compounded return rate”. Some investors might be more familiar with another common term?—?the Annual Average Return (AAR). Investors typically see that annualized rate of return in mutual funds that report historical returns for say a three-, five- or 10-year period. However, IRR is a preferred measure for real estate, because it takes into account an important factor that AAR does not?—?the time value of money.
There are two key differences between an IRR and an AAR.
- An IRR factors compounding into the calculation whereas an AAR does not take compounding into consideration.
- An IRR is time-sensitive. For example, the faster the distribution of returns, the higher the IRR will be when all other factors remain constant. AAR is commonly defined as the arithmetic mean of a series of rates of return.
One example to help put some of these measures in perspective is CrowdStreet’s posting of Timber Oaks Apartments, a multifamily investment opportunity in the Dallas metro area. The series of targeted cash flows for Timber Oaks is both a 22.7% AARand a 17.8% IRR. The targeted outcome is different because the formulas account for time differently.
As you can see in this series of cash flows, based on a $50,000 investment, we are targeting a total return of $56,726 (total cash-on-cash returns of $17,784 throughout the holding period plus $38,942 of total profits upon sale). Since we are assuming a 5-year holding period, this means we are targeting an AAR to investors of $11,345 ($56,726 / 5) or 22.7% ($11,345 / $50,000). Alternatively, when using the time-sensitive and compounding methodology of an IRR to calculate a return on this same series of cash flows, it yields a 17.8% IRR.
Another important measure for investment opportunities is cash-on-cash returns. Simply put, this calculation determines the income on the cash invested. It is relevant to real estate because investors and developers often leverage their own equity with additional layers of financing when making direct real estate investments. The cash-on-cash return is the annual dollar income divided by the total dollar investment.
Finally, another term frequently used when discussing the purchase and sale of investment property is the capitalization or “cap” rate. The cap rate is calculated by dividing the net operating income (NOI) by the cost or sale price of a property. For example, if an apartment complex has an annual NOI of $500,000 and sells for $10 million, then the property sold at a cap rate of 5%. Some investors also make the distinction of calculating the “trailing cap rate,” which is derived by dividing the property’s trailing 12-month actual net income rather than any future predictions of NOI.
Analyzing different investment metrics can, at times, seem like wading through a thick fog of alphabet soup. The key for crowdfunding investors is to make sure to understand the differences and use the same measures to provide an “apples-to-apples” comparison when considering potential investment opportunities.
FAQs
To get the current return on the total amount of cash in either a property or your portfolio, take your net cash flow after debt service and divide it by your total cash in the deal.
How to determine rate of return on real estate? ›
ROI on a real estate rental property is calculated using the following formula: ROI = (Gain on investment – Cost of investment) / Cost of investment.
What does 1.5 equity multiple mean? ›
Essentially, it's how much money an investor could make on their initial investment. An equity multiple less than 1.0x means you are getting back less cash than you invested. An equity multiple greater than 1.0x means you are getting back more cash than you invested.
What is the difference between IRR and AAR? ›
There are two key differences between an IRR and an AAR. An IRR factors compounding into the calculation whereas an AAR does not take compounding into consideration. An IRR is time-sensitive. For example, the faster the distribution of returns, the higher the IRR will be when all other factors remain constant.
What is the 4 3 2 1 rule in real estate? ›
Analyzing the 4-3-2-1 Rule in Real Estate
This rule outlines the ideal financial outcomes for a rental property. It suggests that for every rental property, investors should aim for a minimum of 4 properties to achieve financial stability, 3 of those properties should be debt-free, generating consistent income.
What are the three ways real estate returns are measured? ›
The typical three “total” return metrics are Equity Multiple, Annualized Rate of Return (ARR), and Internal Rate of Return (IRR).
How do you analyze rate of return? ›
Here's how to calculate annual rate of return: Subtract the initial investment you made at the beginning of the year (“beginning of year price” or “BYP”) from the amount of money you gained or lost at the end of the year (“end of year price” or “EYP.”)2. Divide the difference by the initial investment.
What is a good ROI on real estate? ›
Generally, a good ROI for rental property is considered to be around 8 to 12% or higher. However, many investors aim for even higher returns. It's important to remember that ROI isn't the only factor to consider while evaluating the profitability of a rental property investment.
What is a good IRR for real estate? ›
Real estate investments often target an IRR in the range of 10% to 20%. However, these numbers can vary: Conservative Investments: For lower-risk, stable properties, a good IRR might be around 8% to 12%. Moderate Risk: Many investors aim for an IRR in the range of 15% to 20% for moderate-risk projects.
What does 2X mean in real estate? ›
Conversely, an equity multiple more than 1.0x indicates that you are getting back more cash than you put in. So, if a real estate syndication deal had an equity multiple of 2x over a projected hold time of 5 years, that means that you could expect to double your money during that 5 years.
A 2X is “wow, 200% return!” A 2X in 6 years is an IRR of 12.2%. Not quite as rosy because your money was tied up a pretty long time and bore a fair amount of risk to merely double. (And if you really want to grade yourself harshly, subtract the nominal returns the money would have gotten in your favorite market index.
What is a good equity multiple for real estate? ›
Investors should at least seek equity multiples higher than 1. An equity multiple of 1 indicates that investors received their contributions back. Any multiple less than 1 means that the property had negative returns, and any multiple higher than 1 means the returns were positive.
What is the average annual return on real estate? ›
According to the S&P 500 Index, the average annual return on investment for residential real estate in the United States is 10.6 percent, so anything above that can be considered better than average. Commercial real estate averages a slightly lower ROI of 9.5 percent, while REITs average a slightly higher 11.3 percent.
What is the formula for AAR in real estate? ›
Average Annual Return (AAR)
It is calculated by dividing the total return of the investment by the number of years in the investment period. AAR does not take into account the time value of money. It treats all returns equally, regardless of when they are received during the investment period.
Should IRR be higher than RRR? ›
The internal rate of return rule is a guideline for evaluating whether to proceed with a project or investment. The IRR rule states that if the IRR on a project or investment is greater than the minimum RRR—typically the cost of capital, then the project or investment can be pursued.
How do you calculate total return on real estate? ›
Real Estate ROI is calculated by using the formula (Net Profit / Cost of Investment) * 100. Net profit includes rental income, property appreciation, and tax benefits, while Cost of Investment involves the initial purchase price and associated expenses.
What is a good ROI percentage for real estate? ›
Generally, a good ROI for rental property is considered to be around 8 to 12% or higher. However, many investors aim for even higher returns. It's important to remember that ROI isn't the only factor to consider while evaluating the profitability of a rental property investment.
What is the best way to measure returns? ›
Annualized/CAGR returns
Another way to put this is to figure out that if you have invested an amount over a period of 'n' years, then how much your investment has grown every year (year-on-year) over the 'n' years. CAGR returns (represented by R) can be calculated using this formula: V = P(1+R/100)^n.
What is the 5 2 rule in real estate? ›
When selling a primary residence property, capital gains from the sale can be deducted from the seller's owed taxes if the seller has lived in the property themselves for at least 2 of the previous 5 years leading up to the sale. That is the 2-out-of-5-years rule, in short.
