You have a group you can invest with… and the group is getting ready to invest in a commercial property… and then you get thrown into a sea of terminology! Let’s get back on the boat and figure it out.
There are possibly over 100 financial and operational concepts with related terminology in the world of commercial income-generating properties. We will share many of these through the WealthChakra platform. Make sure you join our group so you can stay connected and learn with us.
For now, let’s talk about the ways in which you, as an investor, will evaluate your returns in a group investment. It basically boils down to figuring how much cash you receive through the period of ownership of the property.
Cash-on-Cash Return (CoC)
This metric tells you how much cash income you will earn as a percentage of the cash you invested in the property. It is calculated by dividing the cash flow by the initial capital investment.
CoC = Cash Flow / Initial Capital Investment
For instance, if your initial investment is $100,000 and you get an average of $7,000 every year in cash flow. Then your CoC = $7,000 / $100,000 = 7%.
Equity Multiple (EM)
This metric tells you how much your invested money will multiply. An equity multiple of 1.9x means that for every $1 you invest, you will get a total of $1.90 back through the life of the project. EM is calculated by dividing the sum of the total net proceeds (cash flow + sales profit + return of capital) by the capital investment.
Let’s say your capital investment in a group is $100,000 and you receive $7,000 cash flow every year for 5 years for a total of $35,000. When the project is sold after 5 years, let’s say you receive your original capital and also an additional $50,000 in profits from sale.
EM = ($35,000 + $50,000 + $100,000) / $100,000 = 1.85.
So the project will say your Equity Multiple is 1.85x.
Internal Rate of Return (IRR)
This metric is used to estimate the profitability of an investment including the time value of your money. Equity multiple helps you understand the expected return on investment at the end of a project. The IRR tells you the average annualized rate of return expected over the lifetime of your investment.
IRR combines both profit and time into a single metric expressed as a percentage. So an IRR of 10% at a particular point in time would imply (very simplistically) that you are receiving an average return of 10% on your investment annually until then. This is not an actual 10% but rather it is the average up to the time of measurement. IRR tends to be an esoteric idea for most investors. If you’re interested in getting a deeper understanding of IRR, read this article.
An important thing to understand is that while IRR combines the time value of money and opportunity costs, it can also be very misleading. For instance, a 16% IRR over 18 months may sound great, but might only provide a 1.1x equity multiple because while you got back your money quickly there wasn’t enough time to grow in value. Rather than recycling that capital and finding a new investment, it might be better to have a lower 12% IRR investment for a longer duration of 5 or 7 years and receive a lot more cash flow and higher profits through the life of the project.
Annualized Average Return (AAR)
This metric is a combination of the cash flow and sale profits and tells you the rate of return for the cash you receive through the project if it was evenly distributed every year. Let’s use the example above in the Equity Multiple metric description.
Total cash flow received over the 5 years = $7,000 x 5 = $35,000
Total profits receive at sale = $50,000
Total cash received through the life of the project = $35,000 + $50,000 = $85,000
Average Cash Returns = $85,000 evenly divided across 5 years = $17,000 annually
So, the AAR = $17,000 / $100,000 = 17%
This gives you an easier understanding of the actual returns. In some projects, you might see that the CoC is high but the sale profits are low and in some cases it’s the reverse. Don’t assume that the one with the high CoC is more attractive. Look at (or calculate) the AAR to make a more apples to apples comparison.
While no single metric is perfect on its own, when used together, the CoC, EM, IRR, and AAR all complement each other and give you the tools to understand a deal’s ultimate profitability, expected distribution schedule and corresponding opportunity costs.