In the below, we’ll delve into the top 10 metrics that all real estate investors should understand before investing a single penny in a deal. These are the metrics that we believe, once understood, best inform an investor’s decision to pull the trigger or not.
1. Cash-on-Cash Return (c-o-c)
Cash-flow divided by cash invested. This is perhaps the easiest to understand and most commonly-used metric in real estate. Put simply, this is just the amount of cash you get out for the amount that you as an investor put in. Typically, you will see or hear other investors & sponsors talk about a deal’s overall cash-on-cash return. This is calculated by averaging the annual cash-on-cash returns throughout the life of the deal. When evaluating a deal, it’s important to examine the deal’s cash-on-cash return during every year of the proforma underwriting. If cash-flow is very low throughout the life of the deal, maybe that means this deal’s return depends not on the income side but instead rests more on capital appreciation. That may be too speculative for your risk appetite. Or it might not match your desired return profile if for example you’re looking for an investment to support your lifestyle through monthly cash-flow. However, you may see certain deals where the c-o-c is low in the early years while the operator/investor implements a large capex program, and thus there’s little cashflow to be had early on. Later on, once the renovations are done and the property is stabilized, the c-o-c may rise to reflect higher rents, lower expenses, etc. Understanding the cash-on-cash story will tell you a lot about a deal but is just one piece of the puzzle. Enter IRR…
2. Internal Rate of Return (IRR)
The 800 lb. gorilla in the room. In our opinion, IRR is the undisputed heavyweight champion of return metrics related to multifamily real estate. Both elegant and comprehensive, it is perhaps the truest mathematical measure of an investor’s potential return on a deal. Simply put, IRR is a summary statistic of cash-flows. It’s the rate at which the money you invested grows on a compounded basis. Said differently, it’s the rate of growth that equates the money you put in with the money you pull out of a particular deal. Because IRR involves compounding, it is said to reflect what we in the financial world call the time value of money (TVM). This means that IRR will weigh $1 received today as more valuable than $1 received 10 years from now. For more on the concept of TVM, try this video.
IRR is one of the most widely-advertised statistics in real estate investing. You’ll see investors promote their 20%+ targeted IRR deals, but how certain can you be that these returns are realistic? There’s the rub, friends. Unfortunately, IRR’s greatest strength is also its greatest weakness. The fact that it boils all of the particulars of a deal (literally tens to hundreds of individual assumptions) down to one number should give an investor pause. That’s why it’s so important that you not simply compare the target IRR of one deal or one deal sponsor to another—they could be operating on an entirely different set of assumptions! A conservative deal sponsor could be advertising that their deal will return you 12% while another sponsor aggressively markets their deal as returning 25%. Does that mean you should blindly go with the higher return deal? NO! You can’t simply compare IRR’s without understanding what goes into them and how aggressive/conservative those assumptions truly are. Both sponsors should be questioned so you as an investor can understand the underlying assumptions baked into each. As a benchmark for investors, while I have seen target IRR’s marketed above the 20% threshold, I’d dig a little deeper if you see a sponsor too much higher than that level. Either the sponsor is underwriting to a very optimistic scenario or they’re taking a lot of risk on their deal. As they say on Wall Street, there’s no such thing as a free lunch—higher return often comes at the cost of higher risk. When you see a return that looks too good to be true, ask what risks are being taken in order to achieve that.
Side-note: On the subject of how to calculate IRR, unfortunately due to its complexity, IRR can only be solved for iteratively. However, many computer programs (including Excel) and financial calculators have an IRR function that allows the investor to calculate IRR for themselves. Don’t get too hung up on the math.
3. Equity Multiple
This metric, like cash-on-cash return, is easily understood by most investors. It’s usually quoted as “3x” or “2.5x” to signify how many times the money you initially invested is worth at the end of the investment lifecycle. For example, an investment that has an equity multiple of 2.75x means that for every dollar you initially put into an investment, you’re getting back $2.75 total (For a 175% profit on your equity) by the time the asset is sold. While it is straightforward, this metric belies the fact that you don’t know when you’re actually receiving your return—ignoring the time value of money concept covered in the IRR summary above. For example, you might be evaluating two different investments where the first pencils to a 2x multiple while the second returns 3x your money. Looking simply at these metrics without any other information, you might conclude that the 3x is a better use of your capital. However, what if the 2x is returned in 3 years while the 3x deal is a 10 year investment? Or how about evaluating a 2x deal where most of your money is made in the first 2 years of a 5 year investment vs. a 2x deal where you get most of the return back upon sale in 5 years? Clearly, equity multiples are best judged in light of how long it takes to receive them as well as the relative risk of the particular investment. As with many of the metrics we’ll cover, equity multiple is great when used in tandem with other measures, but less so when evaluated on a standalone basis.
4. Average Annual Return (AAR)
Like the three metrics discussed so far, the AAR is a measure of return. AAR is simply the average of annual returns across the life of the deal. If for example, if an asset produces 5%, 8%, and 26% returns during each year of its 3-year holding period, the AAR would be 13%.
(5% year 1 + 8% year 2 + 26% year 3) / 3 years = 39% / 3 = 13% AAR
Of the three metrics previously discussed, AAR is most similar to IRR but with a few key distinctions. First, AAR doesn’t consider compounding like IRR does. Second, AAR isn’t time sensitive and thus doesn’t consider the time value of money (covered in IRR section). This means that mathematically a $100k profit in year 1 is considered the same as a $100k profit in year 10 for AAR purposes. Whereas one of IRR’s key assumptions is that $1 in year 1 is worth more than $1 in ten years. For that reason, AAR is considered a theoretical lightweight compared to IRR in the world of financial math (this coming from a card-carrying financial math geek). However, depending on an investor’s level of sophistication, it may make more sense to use AAR when describing returns for sheer simplicity of its explanation.
5. Net Operating Income (NOI)
For those of us who aren’t accounting-inclined, NOI is the asset’s profit before debt service (mortgage payment). To calculate it, one would subtract all of the property’s normal operating expenses (costs to run the asset) from its income. It’s a metric that helps an investor determine the profitability of an asset without taking into consideration how one finances it. You might ask yourself why does this calculation not include debt service? The answer is simple. You want to be able to compare one asset’s profitability to another asset on an apples-to-apples basis. Including the debt service complicates this analysis because your choice of financing will impact how each deal looks. As we’ll see with the next metric, NOI is used to value a building based on its profitability. Thus, it’s important for diligent investors to analyze the NOI that sellers report in their offering memorandums (think brochure) to validate/verify them. If a seller accelerates or outright invents reported income, that will artificially inflate the NOI. On the flip side, if a seller defers or ignores certain expenses from their financial reporting, this will also inflate NOI. In both cases, using an inflated NOI to analyze a deal would likely cause an investor to overpay for the asset. This illustrates why it’s so important to underwrite deals prudently and understand these calculations thoroughly.
Sidenote: NOI is also used in the Debt Coverage Ratio and Cap Rate calculations which are covered later.
6. Cap Rate
In simple terms, cap rate is a property’s NOI divided by the price at which you purchased it. Cap rate varies by market, sub-market, tenant quality, building vintage, and size of the building. Higher risk investments tend to come with higher cap rates: the famed risk-reward tradeoff. A building in the middle of a thriving city may have a lower cap rate than the same building if it were located in a small rural town. Straightforward enough, right? Time for a plot twist.
As easy as it might be to throw around your ridiculously high purchase cap rate (the cap at which you bought an asset) when bragging to friends about your latest deal, doing so might just be a fundamental misunderstanding of the term. You wouldn’t be alone in doing so either. If you surveyed 100 investors on cap rate’s meaning, you’d likely hear the following definition 99 or so times: “It’s the return you’d make if you bought the asset with all cash.” While technically true (if we willingly ignore closing costs, rehab costs, reserves, etc.), we would pose a different way of thinking about cap rate. More accurately, it is a measure of market sentiment*. For example, if a particular market is trading at a 5 cap, that really doesn’t tell you anything about your potential return as the textbook definition might suggest. Instead, it tells you what investors are willing to pay on average for an income stream in that market. The lower the cap rate, the more that investors are willing to pay for a dollar of income and vice versa. So, if you’re looking at a market that’s trading in the 3-4 cap rate range (think Manhattan, NY) vs. another trading in the 6-7 range (think rural parts of TN), it’s safe to say that investors are willing to pay materially less for a dollar of earnings on the latter. For this reason, rather than a return metric we believe it’s more accurate to think of cap rate as a measure of market sentiment/appetite for risk.Stay tuned for future newsletters where we’ll discuss why we believe cap rate may not be all it’s cracked up to be. While we hate to beat up on cap rate, the real estate investment industry seems to tout it as the end-all be-all of deal metrics. We believe that cap rate, as a snapshot of how the asset is performing today, is just one of many metrics to follow when looking at a potential deal.
* Financial nerds like ourselves might say that cap rate represents the “risk-free rate + risk premium” of a particular market/asset. We’ll go back to being stuffed in our locker now.
7. Vacancy Rate
Vacancy rate can be a very useful metric to the discerning investor. Vacancy can take two forms: (1) physical vacancy which tells us the percentage of units which are actually physically un-occupied and (2) the all-important economic vacancy which tells us the percentage of units that are not paying. It’s one thing to have 2% of units physically un-occupied but quite another if 15% of said units are actually not paying. So obviously high vacancy, whether physical or economic, is an opportunity for a savvy investor to add tremendous value to an asset’s operations by reducing it. Interestingly though, a very low vacancy rate may also be indicative of an opportunity. If an asset is consistently running close to 0% vacancy, that may mean rents are set too low for the area and there’s room for an operator to increase rents to market rate. An asset that’s managed correctly may run in the 4-6% vacancy rate depending on the market and asset/tenant class. That range, based on our experience, seems to balance having too many units vacant vs. having rents set too low.
8. Break-even Occupancy
In order to understand breakeven occupancy, let’s first define occupancy itself. Occupancy is the inverse of the vacancy metric covered just above. So, if for example you have a 5% physical vacancy, that means your asset is 95% physically occupied. Breakeven occupancy is the economic occupancy rate at which an asset’s income (aka effective gross income) just covers the asset’s operating expenses and debt service (mortgage payment). This metric is important for investors to understand as it tells them the occupancy threshold where the asset no longer covers its expenses. For example, a 70% breakeven occupancy means that the building could be as low as 70% economically occupied before it could no longer cover its expenses. Said differently, the building can have as high as a 30% of units not paying before the same. As a risk measurement, it’s preferable to have as low of a breakeven occupancy as possible. This makes sense because theoretically the lower the breakeven %, the more down-side protection an investor has before the asset can’t cover its costs from the income coming in. The lower the better, and we prefer to see 70% or lower on the deals we acquire.
9. Debt Coverage Ratio (DCR)
DCR is an important risk metric that both lenders and investors use. It tells you how many times over the asset’s NOI covers its debt service (mortgage payment). Recall from above that NOI is the amount remaining after subtracting operating expenses from the effective gross income. To illustrate the DCR concept, if a particular deal you’re evaluating has a 1.40x DCR, that means that the income remaining after paying operating expenses (the NOI) covers your debt service by 140%. Said differently, NOI could decline by 40% before the asset could no longer cover its debt payments. Obviously, the higher this number is, the more protected the lender feels and the more cashflow will ultimately be available to equity investors. Conventional bank and agency lenders typically require between 1.20-1.25x DCR in order to approve the financing while bridge lenders may require much less. DCR will usually increase over the life of the deal as the spread between your income and expenses goes up. However, if you see DCR going down temporarily in a deal proforma you’re evaluating, it may not be a sign that something’s wrong. If for example a deal calls for a refinancing in the out-years that increases the outstanding loan amount, you may see this ratio lower temporarily until rents can catch up with the newly increased loan amount. If you see DCR declining in a deal proforma, you should ask why the sponsor projects this to be the case. We look for DCR’s in the 1.40-1.50 minimum range on the deals we engage in.
10. Expense Ratio
Similar to breakeven occupancy, expense ratio is a percentage but it measures how much of the effective gross income (aka the actual collected income) goes to pay the operating expenses of an asset. It doesn’t include debt service for the same reason that NOI doesn’t include it: including the mortgage payment would skew the metric according to the financing choices the investor makes, and thus would not strictly reflect the performance of the building itself. The expense ratio answers the fundamental question, “how much of this asset’s income goes to pay its operating expenses?” Usually, for commercial multifamily properties, the expense ratio tends to be in the 35-55% range depending on the asset’s size, vintage, condition, and location. When evaluating a deal based on financials provided by the seller or seller’s broker, an investor should view the expense ratio with some skepticism. Often, the expenses in the financials supplied by the seller will NOT reflect all of the costs that it would take for YOU to run the building. That doesn’t necessarily mean they’re lying though. They could (a) not have a great bookkeeping process or professional overseeing their accounting, (b) be managing the asset and thus performing much of the work themselves, or (c) be deferring necessary maintenance on the building. Thus, you’ll want to underwrite and later make your offer based on what it will cost YOU to run the asset, not prior management. On the other hand, if the expense ratio looks too high, this may mean either there are opportunities for you to lower these expenses (and thus increase the value of the asset) or they may simply have rents set too low. Either way, a high expense ratio might spell opportunity for the savvy investor.
We’ve now covered what we believe are the top 10 most important metrics in multifamily real estate. Understanding these metrics will help investors spot opportunities and avoid potential pitfalls as well. But, as powerful as they are, no one metric tells the whole story. To truly understand a deal’s risk/reward dynamic, one must evaluate each metric as they relate to each other. For example, is a deal projected to have a high IRR but yield low cash-on-cash? That might mean that a lot of the deal’s return is tied to capital appreciation and ultimately achieving the right sale price. Sure, the equity multiple may look very attractive on another deal. But that may only be because a deal’s exit cap rate (the cap rate at which you sell) is underwritten unrealistically low. These are just a couple examples but we think you get the idea: in order to evaluate a deal’s merits, you must take all of these metrics into consideration.