In our previous article, Passive Real Estate Investing KPIs - Part 1 - Which Investment is Right for You?, we reviewed KPIs that are widely used to compare a range of investment opportunities and assess the value to investors as projects manifest. While these KPIs have their place, they have the limitation that they don’t fully account for the time value of money.
One essential aspect of judging investment opportunities is to understand the Key Performance Indicators that the real estate industry uses to assess the potential risk and reward of an investment, as well as to gauge success or failure through an investment’s lifecycle. You can’t fully assess the value of a project without taking the time value of money into account.
With this in mind, we’ll introduce an essential passive real estate investing KPI, IRR, or Internal Rate of Return.
The IRR metric accounts for a few things that are important. One is the opportunity cost of investing in one real estate project over another. Most investors have to make choices in how they allocate their capital across a real estate portfolio (or more broadly, across all investment options), and IRR is a great tool to evaluate how to prioritize those allocation decisions.
The other thing that IRR accounts for is the time value of money. Using IRR lets you weigh projects not just on when cash may be returned to you, but also factors in how quickly (and at what magnitude) cash disbursements happen. Cash disbursements far in the future are worth less than cash that you might get access to tomorrow, and IRR accounts for that.
To calculate IRR, you look at the timeline of cash flows generated by the investment. The cash that comes back in from real estate investments can be quite varied in nature. It may be in the form of deposits received for home construction sites, monthly apartment or office rental streams, or the ultimate sale of the asset. By discounting these cash flows back to the current period, you can calculate what interest rate would have generated those cash flows based on the amount and timing of your investment.
This is your IRR. It’s a neat measure as in passive real estate investing, cash flows and disbursements back to investors may not come in even increments. A stream of rents for years accompanied by project improvements and then a large sale of the project in a lump sum at the end may have a very different value than a set of home sites that are developed and sold within a few years. How would you decide between these two opportunities? One way would be to discount these payments back to the initial invested principal amount and calculate the resulting interest rate that makes the two balance out. This lets you use a consistent KPI to compare two very different types of investment opportunities.
You can then evaluate the IRR against the potential risk of a project and determine your risk-to-return tolerance using real data.
A Second KPI that we like to measure is Cash on Cash Return.
Cash on Cash Return, sometimes referred to as Cash Yield, is a key performance indicator more often used in evaluating commercial real estate investment opportunities than other investment types. It’s a shorthand way to evaluate the investment returns provided by the operations of the property, not value derived from appreciation and the ultimate sale, relative to the cash invested in the deal.
Cash on Cash Return helps you to understand the actual cash benefits to you of the cash you’ve invested. Commercial Real Estate investments are often supported by both equity and debt. While an ROI calculation would factor in both the equity and the debt used to fund an investment, cash-on-cash analysis only factors in the cash that you provided, providing greater clarity of the actual value to you of an investment.
Cash on Cash Return doesn’t consider non-cash factors such as depreciation and is often calculated on an annual basis so it gives a nice ‘what are you doing for me today’ feeling for an investment.
We use this metric to better understand how much of the total return expected from an investment is derived from the property operations vs derived from the appreciation and sale of the property. For example, if an investment is expected to deliver a 15% IRR in total, and the cash-on-cash return is about 10%, then approximately 5% (or ⅓ of the total return) would be associated with appreciation on the property. The higher the contribution of the cash on cash return is to the total return of a deal, that deal typically assumes less underlying appreciation on the property. These metrics can be used, relative to the business plan, to build a more comprehensive view of the risk and reward potential of a given investment opportunity.
Using these two passive real estate investing KPIs will be a guide to developing your portfolio investment strategy. JLAM has a well-established track record of selecting and executing investments that deliver outsized returns and can provide guides to what you might expect for these key KPIs in a well-managed real estate investing strategy.