5 Must-Know Real Estate Investment Returns Metrics
One critical aspect of evaluating a commercial real estate (CRE) deal (from any point of view), is understanding what the investment return metrics mean for the buyer. Those metrics can essentially signal whether the return is commensurate with the level of risk the buyer is willing to take on.
For investors, brokers, and other commercial real estate professionals alike, it’s important to be familiar with a few key investment metrics, all of which we’ll cover in detail below.
Key Investment Metrics for Commercial Real Estate
For the sake of example, let’s say that you’re making a $100k investment in a value-add apartment property that has a projected 10-year hold period and is located in a growing neighborhood in Brooklyn.
1. Capitalization Rates (Cap Rates)
First and foremost: cap rates.
A property’s cap rate is the yield on cost, expressed as a percentage.
The formula for cap rate is as follows:
Annual Adjusted NOI / Purchase Price
The exit cap rate, otherwise known as the terminal cap rate, is a key metric to sensitize, as well.
Aggressive exit cap rates can greatly impact projected investor returns for both the internal rate of return and the multiple on equity (see definitions for those below).
Given a projected long-term hold period of ten years, the internal rate of return and multiple won’t be highly sensitive to shifts in the exit cap rate.
Now, to be frank, predicting an exit cap rate ten years down line is essentially a shot in the dark.
However, in this case, since the returns are fairly insensitive to the exit cap, an investor could be a little more confident in the investment—as long as the sponsor makes a conservative assumption that accounts for the quality of the property and its market.
Generally, insensitivity to exit cap rates is a quality to look for in any commercial real estate deal.
2. Internal Rate of Return (IRR)
The internal rate of return (IRR) is a bit more complex of a metric. It is an annualized rate of return that’s also expressed as a percentage.
One of the complexities of IRR is that it assumes that positive cash flows are being reinvested in the transaction and actually earn the IRR—meaning, if the IRR is 10%, positive cash flows to equity would be compounded at 10%.
Because it’s an annualized metric, if the investment spans 12 months, the IRR will be the same as the overall return on that investment.
A few other facts about IRR:
It always starts infinitely negative (before any capital is returned).
It becomes less and less negative as capital is being returned over time.
It becomes 0% at the point of all capital being returned (breaking even).
Then it becomes positive and becomes incrementally greater with each additional dollar of positive levered cash flow generated.
For a light value-add deal in a quality market, an upper-teens IRR percentage is typically a solid return.
3. Cash-on-Cash Return (CoC)
Cash-on-cash return is expressed as a percentage as well, and is calculated as shown below:
Annual pre-tax cash flow / Total cash invested to-date
Keeping that $100k investment example in mind:
If you had an 8% cash-on-cash projection for year one, for instance, that would mean that you’d receive an 8% distribution on your original invested equity of $100,000.
8% of $100,000 = $8,000
That $8,000 will factor into both your equity multiple and internal rate of revenue.
Cash-on-cash returns are typically calculated using unreturned equity.
Net cash-on-cash return would reflect the projected distribution to investors after taking out asset management and other sponsor fees.
In this particular case, if the sponsor were to return 50% of equity through a refinance (equalling $50k), the investor’s cash-on-cash returns would be calculated using the remaining $50k of unreturned equity.
If you’re an investor, you should be looking for deals that have strong initial cash-on-cash returns, as well as strong returns across the hold period.
Even if cap rates were to take an unexpected hit, you’d still get significant equity returned to you throughout the hold period.
4. Stabilized Return-on-Cost
Return-on-cost is similar to cap rate, but is more forward-looking, as it looks at the net operating income of a property after it’s been stabilized.
Return-on-cost is also expressed as a percentage, and is calculated as:
Net cash flow (before debt service) / Sum of acquisition price, closing costs, and renovations costs
Cap rate is much more often quoted than stabilized return-on-cost. The return-on-cost might actually be more relevant, however, since it takes all expenses into account, including leasing costs and recurring replacements.
The metric is calculated using the cost basis, not the price of purchase.
The stabilized return-on-cost should be a few hundred basis points premium to rates for prevailing markets—it signifies the value that has been added to the asset.