If you’ve ever looked at investing in commercial real estate through a real estate syndication, you’ve likely seeing the terms cash on cash return, internal rate of return, average annual return, preferred return, and equity multiple.
While these are all a measure of return, they are all unique and we’ll break them down below.
1. Cash on Cash Return (CoC return)
A calculation that refers to the return on invested capital, or the cash income on the investment.
For instance, if you invested $100,000 and the investment returned $8,000 to you in one year, your cash on cash return is 8%.
This simple equation is determined by taking the annual dollar income return divided by total amount of investment.
Many of the deals we put together and invest in ourselves have an increasing cash flow each year as the property improves and rents are increased.
Also, with increased rents comes increased cash flow, it allow us to distribute more to our investors each year.
For example, on a $100,000 investment, you may see the following distributions:
Year 1: $7,500, Year 2: $8,000, Year 3: $8,600, Year 4: $9,300, Year 5: $10,000
Finally, we determine our average Cash On Cash return over the 5 year hold is 8.68%.
2. Internal Rate of Return
The rate of return that makes the net present value of all cash flow equal to zero.
This one is sometimes the most difficult to explain but a more sophisticated measure of return. Like, the higher the projects IRR the more desirable it is to undertake the project.
The IRR is often a good investor metric to compare similar projects with different or varying pay out streams.
Also, Investors that get more money early in the life cycle will have a higher IRR than one that pays off only with a sale in say 5 years.
It’s important to note that IRR starts out infinitely negative and become less negative as capital is being returned. Once all capital is returned to the Limited Partners, then their IRR is 0% at that point.
It’s only a positive return once you get distributions above and beyond initial investment, which typically requires a sale or refinance.
We like to invest in opportunities that are expected to produce mid-teen IRR’s with a value-add component in a quality market.
3. Average Annual Return
An annualized total return is the average amount of money earned by an investment each year over a given period. It is calculated as a geometric average to show what an investor would earn over a set time period if the annual return was compounded.
Here’s an example:
The investment earned $85,672 over 4 years.
Divide that number by the 4 years equals $21,418 as an average annual return.
Divide $21,418 by the initial investment amount of $100,000 to calculate the average rate of return of 21.42%.
In value-add syndication, the average annual return may be deceiving (higher) than the IRR (Internal Rate of Return) as a large part of the investor returns come in the year of sale (modeled as year 5).
IRR typically would be a better measure for varying cash flows over a set time horizon. Think about the time value of money. Would you rather have $1 today, or $1 in say 5 years?
4. Preferred Return
Not a guarantee, but the next best thing for investors. The preferred return or “pref” is a return to a limited partner in an investment syndication that is paid first before the general partner gets paid their share of distributions or profits at sale.
Typical preferred returns on real estate syndications are right around 7-8%. Preferred returns should be cumulative and accrue to investors each year if the investment falls short of the target.
Deals are usually structured to have this be an annual target for the investment hold period.
So, an 8% preferred return over a 5-year hold period would mean investors are targeted to be paid up to 8% each year over that time span.
If the investment earns 6% in one year, then the following year the new pref target is 10% (8% target plus 2% catch up from prior year) and so on until the investor is caught up.
That is cumulative and accrues to the investor and should be paid before general partners get their split on the cash flow or capital events like refinances or sales.
That is why we think its so important for investors to see this in the deal, it’s an alignment of interests with the investor being put first.
5. Equity Multiple
This is a popular and easy metric to understand. If I invest $100,000 and it grows to $200,000 (including distributions and sale profits) then it’s a 2x (double my investment).
If it grows to $185,000, then it’s a 1.85x.
The higher the multiple, the better the return.
Most of the deals we review are for a typical 5 year hold period and target a 2x multiple.
As we’ve written about earlier (link IRR vs. EM article), when focusing on wealth building you’ll want to really take a close look at the projected EM both on the opportunity you are considering as well as the Sponsor’s track record of producing an EM.
IRR can be manipulated, EM cannot.
In summary, passive investors (i.e. Limited Partners) have different goals and may place a heavier emphasis on certain return metrics over others.
However, understanding these 5 return metrics as a whole is a great foundation to analyze your investment opportunities.
There are many more common financial metrics and key terms you want to understand before investing in a syndication, but these should provide a solid foundation when it comes to expected returns and understanding the differences between them.
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