In this episode of The Inside Look, Senior Commercial Real Estate Economist Xander Snyder shares three return metrics every CRE professional should know.

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Transcript:

A Measured Perspective

CRE is typically viewed as a financial asset – meaning people purchase it strictly as an investment.

There are some owner-occupied examples, but most companies choose to rent their space, and instead invest their capital in the thing they are experts at (like their business).

This means that the flow of capital and transaction activity is driven in large part by what sorts of returns investors think they can achieve by purchasing commercial property. But there are several ways to measure returns, and each metric tells you something a little bit different about the building being analyzed.

Equity Multiple

Let’s start with the simplest measure: equity multiple. This is sometimes referred to as multiple on invested capital, or MOIC.

This simply measures how much money has come out of the investment in the building relative to the money that was put in.

If you invested $1mm in a building, earned $500k in income over the life of the investment, and received $1.5mm in proceeds when the building was sold, you would have earned an equity multiple of 2.

The equity multiple tells you the total amount you’ve earned relative to your initial investment, regardless of when you received those distributions.

Cash on Cash

Most real estate investors want to own property at least in part because of the income it generates. Your cash on cash yield is a measure of how much income you receive each year relative to your initial investment. It does not measure the total return you receive from the investment after accounting for proceeds at a sale.

So, let’s say that you invested $1mm in a building, and after paying debt service you’re left with $50k in income. That would result in a cash on cash yield of 5 percent ($50k/$1mm).

Note that your cash on cash is NOT the same as a cap rate. A cap rate measures the income generated by a building, whereas a cash on cash yield measures the return to equity investors in a building after accounting for debt service.

IRR

The last return measure we’ll cover is the internal rate of return, or IRR. This one is the most complicated of the three to understand, since it takes into consideration the timing of cash flows throughout the investment in a way that the others don’t.

This concept, called the time value money, is simply the idea that to tie your money up for some period of time you demand compensation for it in the form of a return. Tying up your money for longer usually requires greater compensation.

Imagine you have a five year investment that has earned uneven income throughout the life of your investment, and you sold the property at the end of year 5. If you wanted to calculate the IRR for your investment, you’d have to solve the following equation. Don’t worry if you’re not a math person you don’t need to understand the details to walk away with an understanding, but let me explain what these terms mean.

Here, NPV stands for “Net Present Value”, which is the present value of all future cash flows less the initial investment; CF stands for cash flow in a given period, and r stands for some discount rate.

Finance textbooks will tell you that, technically speaking, the IRR is the discount rate that sets NPV to 0 in this equation. Not very intuitive right? 

So, if this is your first time encountering IRR, forget about the formula for now. The thing to take away is that there are several terms, each term represents a different time period, and the time period you receive cash in matters.

For example: Imagine you invest $1,000 in a 5-year project, receive $50 in income in each year, then sell the project at the end of year 5 for $1,500. Although you’re receiving $50 each year income, in present value terms that $50 is worth less and less the further out you receive it. This is due to the time value of money. You’ll notice that if we discount all of the cash flows at 12.75%, we get a present value of $1,000, which is what we invested. Therefore, 12.75% is the IRR.

Like equity multiple, IRR is a total return measure – both income received during the life of the investment and proceeds received at sale.

Events

I’ll in Indianapolis in mid-September to give a talk about the state of the CRE economy at an event being held by First American’s National Commercial Service’s.

I’ll also be in Detroit in mid-October, at another First American Event. If you’re interested in attending either, please reach out to your local First American Representative.