Key Return Metrics Every Real Estate Investor Should Know When Underwriting a Deal
When evaluating real estate investments and the financial potential of an asset, multiple return metrics should be factored into the underwriting process. This article will go through a detailed examination of the following metrics:
Internal Rate of Return (IRR)
Equity Multiple (EMx)
Cash-on-Cash Return %
Yield-on-Cost vs. Cap Rate
Net Operating Income (NOI)
Gross Rent Multiplier (GRM)
Operating Expense Ratio (OER)
Debt Service Coverage Ratio (DSCR)
Loan-to-Value (LTV) vs. Loan-to-Cost (LTC)
Debt Yield
With an in-depth understanding of these ratios, we can gain a thorough understanding of a property and articulate a sophisticated understanding of key performance metrics to investors and lenders. With that in mind, let’s dive into our first metric, the Internal Rate of Return, or IRR.
Internal Rate of Return (IRR)
The Internal Rate of Return (IRR) is a widely utilized measure that estimates the potential of an investment. The IRR, in simplest terms, is the discount rate that makes the net present value (NPV) of all cash flows equal to zero from a real estate investment. This can be considered as the interest rate that inflows (profits) and outflows (costs) balance out over the lifespan of an investment.
The IRR gives investors a single, digestible metric that indicates the annual growth an investment is expected to yield. Unlike simple return metrics, which can fall short in reflecting the time value of money, the IRR takes exactly that into consideration: that is, that a dollar today is worth more than a dollar in the future, primarily due to opportunity cost and inflation.
Consider the purchase of an investment property where cash flows are generated from rental income and the eventual sale of the property. These future cash flows are likely to be irregular, happening at varying times and in varying amounts. When underwriting real estate, the IRR is used to account for these potential inconsistencies. The rate quantifies the desirability of an investment by calculating the interest rate at which the costs associated with the investment equal the benefits. It incorporates the initial investment cost, the future rental income, and the projected selling price to give an overall rate of return in a single metric.
All that said, despite its prevalent use as an investment evaluation metric in real estate, the Internal Rate of Return (IRR) has unique flaws. Investors need to be aware of these shortcomings to ensure a comprehensive understanding of the widely used return metric. Some things to be aware of when evaluating real estate with an IRR are as follows:
Dependence on Reinvestment Assumption
A significant limitation of the IRR is its reinvestment assumption - it assumes that the cash flows generated by the investment can be reinvested at the same rate as the calculated IRR. In reality, the rate at which these intermediate cash flows are reinvested may differ, potentially leading to inaccuracies in projected returns.
Multiple IRRs with Unconventional Cash Flows
The IRR tends to be unreliable when dealing with unconventional cash flow patterns—those that involve more than one change in the direction of cash flow (outflows followed by inflows and vice versa).
Positive IRR and Negative Operating Cash Flows
The IRR calculation includes the initial investment, net cash inflows, and the ultimate sale value of the property; however, the metric may not suffice to capture ongoing operational expenses, leading to a scenario where your IRR is positive, despite periods of negative operating cash flows. For instance, if you purchased an asset expecting significant capital appreciation, but the asset generates negative cash flows due to vacancy or management issues, the IRR might still be positive due to the potential for a lucrative sale in the future, but having negative cash flows could affect your ability to maintain the property or impact your overall investment strategy not necessarily reflected in the IRR itself.
Inability to Account for Absolute Returns
While IRR provides a rate of return helping investors understand the efficiency of their investments, it does not reveal the magnitude of the absolute return. For instance, an investment generating a $100 in profit with an IRR of 50% might seem more desirable than another offering $1,000 in profit with an IRR of 20%. However, the second investment actually delivers a larger absolute return.
Overlooks Potential Risks
The IRR, as a metric, does not incorporate potential risks associated with an investment. Two properties may have the same IRR, but each might carry different risk levels. As such, relying solely on the IRR could result in a skewed perception of investment safety.
It's essential to bear in mind that the IRR is just one component in the toolbox of investment analysis. Despite its limitations, when used in combination with other metrics and assessments, the IRR can provide valuable insights towards sound real estate decisions.
Equity Multiple (EMx)
The Equity Multiple (EMx) reveals the total amount of money an investment returns throughout the term of the investment relative to the amount invested. The formula to calculate the Equity Multiple is:
Equity Multiple = Total Cash Distributions / Total Equity Invested
Here, total cash distributions include all cash returns to the investor, and total equity invested is the initial equity amount.
The EMx enables investors to evaluate the full return from an investment, factoring in income generation and potential appreciation in asset price. A higher EMx represents a larger return on the initial equity investment.
So what’s the drawback of the Equity Multiple? Most notably it’s that the time value of money concept is neglected in the metric. Thus, the equity multiple is insufficient by itself to be a standalone return metric for analyzing investments and must be used in conjunction with other metrics to truly understand the merits and risks of a given investment opportunity.
The Internal Rate of Return (IRR) as discussed in the previous section, is complementary to the equity multiple to formulate a thesis on the profit potential of a potential property investment.
Equity Multiple (EMx) - The equity multiple is the ratio between the total return received from an investment and the initial investment. The ratio represents the number of times the initial investment is anticipated to be returned over the project (or number of “turns” that is).
Internal Rate of Return (IRR) – And to recap, the IRR on the other hand, is the annualized rate of return that would cause the net present value (NPV) of the project’s cash flows to equal zero, or the percentage by which an investment is expected to grow annually. Unlike the equity multiple, the time value of money is factored into the IRR metric.
Cash-on-Cash Return
The Cash-on-Cash Return measures annual returns relative to the initial cash invested in a property. It’s calculated using the formula:
Cash on Cash Return = Annual Pre-tax Cash Flow / Total Cash Investment
The Cash-on-Cash Return metric is beneficial for investors interested in immediate income generation, as it directly compares the annual returns with the initial cash outlay. A high Cash-on-Cash Return indicates a powerful income-generating investment.
Yield-on-Cost vs. Cap Rate
The Yield-on-Cost and the Cap Rate are two critical metrics for evaluating real estate investments, and although sometimes the terms are used interchangeably, they are different and need to be clearly understood. The Yield-on-Cost is calculated as:
Yield-on-Cost = NOI (in stabilized year) / Total Project Cost
Where the Net Operating Income (NOI) is the potential income generated from the property during a stabilized year, and the Total Project Cost includes the cost of acquisition, development, and stabilization.
The Capitalization Rate (Cap Rate), on the other hand, is used to measure the return on an investment property deeming it operates at its full capacity, and is defined as:
Cap Rate = NOI (existing) / Property Market Value
The Cap Rate is a real estate metric that measures the relationship between a property’s net operating income and its value. Yield is a metric that measures the relationship between a property’s income and its cost. There are two ways to look at yield, levered and unlevered, with the difference between the two being the use of debt. The key takeaway is that the cap rate is calculated using a property’s value, and yield is calculated using a property’s cost. At the time of purchase, these could be the same, but over time they will drift apart. Both these metrics provide investors with insight into the performance of real estate investments and are instrumental in assessing and comparing property investments.
Net Operating Income (NOI)
Net Operating Income (NOI) is the annual income (after costs) from an investment property. It is calculated using the formula:
NOI = Gross Rental Income - Operating Expenses
NOI is an essential measure of a property's potential income generation, signaling the effectiveness with which operations are managed. A high NOI indicates profitable operations.
Gross Rent Multiplier (GRM)
Gross Rent Multiplier (GRM) provides a simple measure of the value of an investment property in relation to its gross rental income. It's calculated as:
GRM = Property Price / Annual Gross Rents
GRM offers a quick, high-level analysis of the price of a property compared to its income generation. A lower GRM indicates a more favorable investment.
Operating Expense Ratio (OER)
The Operating Expense Ratio (OER) measures the cost of operating a property in relation to the income it generates. It's defined as:
OER = Operating Expenses / Effective Gross Income (EGI)
A lower OER typically means more efficient property management, making the investment more profitable. By way of an example, a good Operating Expense Ratio for a multifamily property typically falls between 35% and 45%.
Debt Service Coverage Ratio (DSCR)
The Debt Service Coverage Ratio (DSCR) is a measure of a property's ability to generate enough income to cover its debt obligations. It's calculated as:
DSCR = NOI / Annual Debt Service
A higher DSCR indicates that the property is generating sufficient income to cover its debts. A DSCR less than 1 indicates a potential default risk, or that it’s not generating enough income to cover its debt payments.
In general, and these can certainly vary over time and by lender, average DSCR requirements by asset class may be similar to the following:
1.35x - 1.40x for self-storage
1.20x - 1.25x for industrial
1.20x for multifamily
1.25x for offices
1.40x - 1.50x for assisted living
Loan-to-Value (LTV) vs. Loan-to-Cost (LTC)
Lastly, Loan-to-Value (LTV) is a measure of the loan amount relative to the appraised property value, and the Loan-to-Cost (LTC) similarly measures the loan amount relative to the total project cost. The formulas for these two ratios are:
LTV = Loan Amount / Appraised Property Value
LTC = Loan Amount / Total Project Cost
Lower LTV and LTC ratios indicate lower loan amounts relative to the property value or project cost, representing reduced risk for lenders.
In addition to DSCR, the LTV / LTC ratios are one of the most important factors in the approval process. In many cases, a loan will have an acceptable LTV or LTC (e.g. 70%) but will not have a DSCR within a lender's acceptable range. In this case, the loan is considered "debt-service constrained" and as a result, the loan amount must be reduced until the loan gets within the lender's approved range.
Debt Yield
Debt Yield is a metric used by lenders to assess the risk associated with a loan and is defined as:
Debt Yield = NOI / Loan Amount
A higher debt yield can indicate that the property is generating enough income relative to the loan amount, signifying a lower risk to lenders. Unlike other measures of loan risk like Debt Service Coverage Ratios (DSCR), Loan-to-Value ratios (LTV), and Cap Rates, the debt yield is a static, consistent measure. DSCR’s can be reduced by longer amortization periods and lower interest rates, and LTV’s and Cap Rates can be subject to changes in the market that vary the assessed value of properties. As such, vast increases in property value could easily make a loan appear less risky for a lender than it actually is if not taking into account the Debt Yield.
Wrapping Up
In conclusion, the metrics discussed herein provide critical insights into the potential returns and risks associated with real estate investments. By understanding and accurately applying these metrics, investors and lenders can make informed, data-driven decisions that enhance their investment performance over the long term, and the effective use of these metrics will be instrumental in one's ability to effectively assess investment opportunities and drive the growth of their portfolio.
To clearly assess the performance of a real estate investment, consider exploring the industry-leading Real Estate Financial Models built by Realty Capital Analytics. To discuss your deal specifically, feel free to setup a complementary meeting using the link below.