How Far Up, How Far to the Right, and When? A Real Estate Return Metric Glossary

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One of Birgo Capital’s favorite features of real estate — particularly Class B and C multifamily properties — is that they are countercyclical: real estate values tend to move up and to the right, no matter what’s happening to the market in general. Fortunately for those of us who enjoy spreadsheets, there are a multitude of metrics by which to measure this very tendency. You’ve probably sampled the alphabet soup before: IRR, GRM, MOIC, and more — a host of variations on the theme that have spawned a litany of sometimes-confusing terms.

Fear not, faithful reader: Birgo is here to help you sort them out. We’ve already written deep-dives on the most important of these terms (hyper-linked below for convenience), so think of this guide as a cheat sheet: a series of short, simple explanations that you can come back to as you go forth and evaluate properties.

Cap Rate, Cash-on-cash, and IRR

These metrics are among those most commonly cited by real estate investors, and all of them can be valuable tools for, well, valuation. While they do not measure precisely the same data, all of them are — in some way — different ways of answering the same question: how far up, and how far to the right?

Cap rate is a measurement of a given property’s net operating income relative to its price. Arguably the most regularly referenced metric in investment real estate, a deal’s cap rate is calculated by dividing the net operating income of the property in question by the proposed purchase price. Because Cap Rate does not account for leverage, it’s an effective tool for comparing deals that may have different financing terms.  Since the cap rate is essentially the unlevered yield required by an investor for a given asset, it can be thought of as a proxy for investment risk: a lower cap rate indicates increased  investor confidence in the income stream prospectively generated by the asset, and a higher cap rate indicates the opposite. 

Cash-on-cash returns are calculated in much the same way as cap rate. The twist: cash-on-cash can be a levered metric, so you don’t just divide net operating income by purchase price. To calculate, take the annual net cash flow and divide it by the total cash invested into the deal. The annual cash flow consists of any income generated by a property, such as rental income, parking revenue, laundry income, etc.  Next, subtract all property expenses, such as maintenance, insurance, property taxes, and management fees, arriving at the property’s NOI.  While a cap rate calculation would stop here and divide this figure by the total purchase price, to calculate the cash-on-cash return, we further subtract the property’s annual mortgage costs, resulting in the property’s net cash flow. We then divide this number by the total cash invested to arrive at the cash-on-cash return. 

If the lending environment is favorable, cash-on-cash returns can be considerably higher than cap rate, and this metric provides an intuitive picture of investors’ true cash flow experience. Because of these factors, cash-on-cash returns are one of our favorite ways to compare deals on an apples-to-apples basis.

Internal Rate of Return is moderately more complex than the first two metrics and very difficult to calculate without the aid of a spreadsheet. The IRR of an investment is the discount rate that makes the Net Present Value of all cash flows for a given investment equal to zero. More simply, the IRR is the annual rate of growth an investment is expected to generate throughout its lifetime. 

Although more complex than other measures, the IRR of a prospective investment is still a vital consideration, because IRR indicates an investment’s annual growth over its entire lifetime, from purchase to sale. Since IRR accounts for leverage, appreciation, cash flow, and time, it affords a more comprehensive insight into the return you can realistically expect a property to produce in a given period.

MOIC (or EM) and GRM

These terms appear a little less frequently than those discussed above, but they still afford powerful insights into the desirability of a given investment.

The Multiple of Invested Capital (or MOIC; also known as the Equity Multiple, or EM) is easily confused with cash-on-cash and IRR — so let’s disambiguate them. MOIC is a measurement of your return based on capital invested: if you invest $10,000 and return $100,000, the MOIC of your investment is 10x. MOIC, unlike IRR, is time-agnostic: whether you return $100,000 in one year or one century, your MOIC is 10x. Cash-on-cash return is a closer conceptual cousin to MOIC, but there’s still a difference: while cash-on-cash return indicates return at a given point in time (say, one year into the investment lifecycle), MOIC evaluates the return over an investment’s entire life without regard for when cash flows materialize.

Where MOIC is time-agnostic, Gross Rent Multiplier (or GRM) is all about time. GRM is an important investment valuation tool because it answers one of the most intuitive questions any investor may be inclined to ask: “how long will it take for me to break even?” While some securities do pay investor dividends, most rely primarily for growth on the interplay between buy price and sell price. Real estate offers another avenue, in the form of rent payments. GRM measures the effect of rent payments on profitability: the GRM of a given property is simply the number of years required for your investment to pay for itself in terms of rent payments received. While real estate investors can and do generate returns at sale, rent is one of the most attractive features of real estate investment, and is consequently a great reason to examine the GRM of a given deal. Importantly, the GRM is the least holistic metric of those discussed in this piece: it ignores expenses, so it should be utilized cautiously, and in combination with other metrics.

Concluding Remarks

Of course, this brief summary only skims the surface of real estate investment evaluation. IRR, cap rate, and cash-on-cash returns in particular are well worth some theoretical deep diving. If you have additional questions about investment analysis, or are interested in discussing an investment with Birgo, schedule a call with us today.

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