Financial metrics to compare investment opportunities are used by intelligent investors to avoid overpaying for their investments. Additionally, investors use metrics to compare investment opportunities to manage their portfolio. Investors are starting to recognize the superiority of real estate and the extensive list of benefits that come along with it. While many people set out to invest in real estate, few see the level of success that they initially sought. Paying too much for a property could leave you in financial ruin. There are countless opportunities, and sometimes investors can fall in love with a property and the feel of a piece of real estate. The intelligent investor will minimize the emotion in the decision and use various financial metrics to compare investment opportunities. Before buying real estate, you must have a concrete valuation in your head based on financial ratios. Otherwise, you could overpay. Overpaying on a property usually happens because of missing/poor financial analysis or impatience. To improve your financial analysis, you will need the five most impactful metrics to compare investment opportunities, knowing when to use each, and how they grow your portfolio.
Capitalization Rate
When it comes to commercial real estate transactions, the capitalization rate (cap) is the gold standard. The cap rate is the metric to compare investment opportunities that are going to be bought or sold. As the fundamental metric that investors use for portfolio transactions, the cap rate measures the return on investment on a debt-free investment. It is found by taking a property’s net operating income (NOI) divided by the asset value.
Net Operating Income ÷ Property Value = Cap Rate
Assume a real estate asset exists with a net operating income of $250 thousand and an asking price of $2.5 million. This specific deal has a capitalization rate of 10%.
250 thousand ÷ 2.5 million = 10%
To figure the property value based on a specific cap rate, you can switch the formula up slightly.
Net Operating Income ÷ Cap Rate = Property Value
Cap rates are dependent upon the stage of the market cycle, the location of the property, the type of real estate, and the general risk assessment of the property. For example, take two multifamily apartment buildings in Tampa, FL. Both have a net operating income of $300 thousand. Property A is a 12-unit and is located one block from the top beach in the area. Property B is a 24-unit building located three miles inland and surrounded by highways. Which one is worth more? They both would make investors the same amount of money if bought for the same price. However, Building B has more units than Building A, but the less desirable location means that the cap rate will be higher because of the elevated risk. Comparable beachfront properties are 6.5%, while inland comps are 8.5%.
Building A Value: $4,615,400
Building B Value: $3,529,400
Which one is better? It depends on whether you are the buyer or the seller and your investment strategy. Cap rates work inversely, meaning the higher the capitalization rate, the better deal for the buyer, and the lower the cap rate, the better for the seller. If you are the seller, what cap rate existed at the time of purchase? If you are the buyer, what are your investment goals? Do you believe you can improve the value of the building by either cutting expenses or raising revenue?
Whenever buying or selling real estate, you need a clear picture of the capitalization rate of the deal, what the objectives are, and the transaction history of the building. When the other variables are clear, the cap rate is one of the best metrics to compare investment opportunities.
Cash-on-Cash Return
Cash-on-cash return is the investment metric that most people could figure individually. However, it is still one of the principal investment metrics and determines whether an investment is a good fit for your portfolio based on your goals. Cash-on-cash frequently refers to return on investment or ROI. It can be calculated based on the money you generate in a year, divided by what you invested. Although there are methods of inflating the cash invested number to have a greater margin of safety, the simplest way is to utilize the down payment on the property.
Generated Cash Flow ÷ Cash Invested = Return on Investment
ROI is the simplest way to calculate the return generated in a single year. Of course, people use this for bank accounts, stocks, and real estate. The primary benefit of cash-on-cash is maintaining the simplicity of the capitalization rate formula. But it is better able to account for capital strategies such as debt utilization or equity partnerships. When you use debt in real estate, you obviously must pay interest on money borrowed. If you effectively add debt financing, the extra capital can get you purchasing access to a better property while increasing your returns. To figure the cost of liability financing, you must add another step before moving into the standard cash-on-cash return formula. First, calculate the generated cash flow by subtracting the debt service from the net operating income.
Net Operating income – Debt Service = Generated Cash Flow
Let us look at Building B from the cap rate section. There are two financing options you are considering. B-1 is a 30-year mortgage with a 5% interest rate on 75% loan-to-value (LTV). B-2 is a 60% loan-to-value with the same interest rate. With an 8.5% capitalization rate, the value of the building is $3,529,400, and the net operating income is still $300 thousand.
Cash-on-Cash Return
- When the debt amortizes, the annual debt service is $172,194.
- Subtracting the debt service from the NOI leaves generated cash flow of $127,806.
- The investor finances 75% of property value through debt, leaving an equity investment of $882,350.
- Cash-on-cash return is 14.5%.
If we follow the same process, we can find the cash generated for Liability Plan B-2 to equal $162,244. Although the nominal value of the generated cash is higher than plan B-1, it equates to a cash-on-cash return of 11.5%. At this point, the investor goals should dictate which project is better. Containing higher returns and higher risk, plan B-1 might belong in a portfolio with better risk tolerance.
Using cash-on-cash return gives investors another metric to compare investment opportunities and determine whether the investment is a good fit for them. In addition to all the factors that play into the capitalization rate, cash-on-cash brings in the capital structure to dictate project performance.
Return on Equity
Cash-on-cash return is perfect for looking at the performance in the first year or one singular year. When examining multi-year real estate projects, cash-on-cash falls in its efficiency in predicting how long a project should last. Return on equity (ROE) is more usable for longer-term projects measuring your return on all capital invested.
When you use debt on real estate projects, you pay off the amortized debt as time passes. Each payment made increases the equity in the building and on your balance sheet. When amortized, debt payments start with considerable interest payments as investors pay reduced principal payments. As time progresses, the interest payments decrease, and the equity payments increase. If you want to figure the return on equity of a real estate project, there are four different formulas that you could use to find this significant ratio. The formula you choose to use does not matter much, but it is critical that you use the same recipe each year to compare the performance of your investment to itself and other assets in your portfolio.
ROE Formula Variations
Formula 1 is the most straightforward way of finding the ROE financial ratio. It uses net operating income and divides it by the ending equity to discover the return. This equation will typically be the highest of the three due to not considering much else besides the strict property performance. Use this formula to see how the property performs and impacts your portfolio instead of the strategic decisions that go with it.
Net Operating Income ÷ Ending Equity = Return on Equity
Formula 2 takes a similar approach but takes it a step further. Instead of using net operating income, it uses the bottom line, considering some of the financial benefits of property ownership such as depreciation, interest write-offs, and tax expenses (depending on what legal entity your holding company qualifies as). Use this formula when you are interested in including some of the financial strategies you are considering.
Net Income ÷ Ending Equity = Return on Equity
Formula 3 takes ROE and gives it a cash emphasis. This formula starts with cash flow and divides it by the total ending equity of the asset. Use this formula to use a more cash basis and see how your bank account improves each year. While investors must pay back their debt to the lender, the equity they build is their money. Therefore, an investor may opt to add the principal payment to the cash flow for a more thorough picture of their portfolio’s return.
Generated Cash Flow ÷ Ending Equity = Return on Equity
(Generated Cash Flow + Principal Payment ÷ Ending Equity = Return on Equity
Because of increasing principal payments, ROE will decrease every year by default. The way to prevent this from happening is by enlarging the net operating income each year. As the equity in the property rises, maintaining a consistent ROE becomes harder and harder for the simple fact that more income is needed. While a continual decline is not necessarily a fundamental issue, looking at ROE through this lens can be an excellent metric to compare investment opportunities when you already own one. It also dictates whether an investor should move towards a project exit. Once the ROE dips below an investor’s set threshold, the investor can move towards a project divestiture.
Continuing with Building B from our initial assessment, compare the four different ROE formulas for comparing the performance of your investment each year.
Internal Rate of Return
When an investor achieves exceptional financial knowledge, one of the most used ratios is the internal rate of return (IRR). At Eikon Investment Group, this is one of the metrics we use the most. IRR reigns supreme for measuring the speed of investment returns and the liquidity of those returns. The internal rate of return derives from a related financial calculation, net present value, or NPV. NPV is the sum of all future cash flows discounted by a cost of capital or discount rate, or the rate of return that investors expect to get back. Found through a complex formula, IRR is the calculated rate of return on a project or the discount rate that would make the net present value of a real estate project equal to zero. Using the IRR () function in Microsoft Excel and selecting a range of future cash flows or through most financial calculators gives you an easy method of calculating IRR.
The leading benefit of using the NPV financial metric is seeing the future cash flows and accurately attributing it to a value of what it would be worth today if investors wanted a particular IRR. While the principal portion of debt service is considered a return, this money is not easily accessible.
IRR with our Example Property
Let us examine our example property once more and assume that the property. This property initially started with a 75% loan-to-value; over the past ten years, the investor has grown the equity portion to 61%, gaining $500 thousand. Knowing this is the proposed schedule we can plan a refinancing exit strategy in year ten when our ROE falls below our desired threshold. Our initial investment was $882,350, and we received positive cash flows of $127,800 each year. In year ten, we recapitalize our deal to have the original 75% loan-to-value, pulling out the acquired $500 thousand. Based on the distribution schedule of these returns, the IRR for the project is 12.03%.
Now consider that the investor decides it will be better to sell after examining the market cycle and realizing that he can add value to the property. By investing an additional 5%, the investor can improve the property, which would increase the net operating income by 2% in the first year and cause 1% operating income growth each year. By adding value, minimizing risk, and selling at a more favorable time, the market cap rate at the time of the sale is now 7.5%. After paying back the remainder of the loan and closing costs, this investor saw a 22.78% internal rate of return.
Of all the metrics to compare investment opportunities, internal rate of return has become a favorite of most investors due to the complete story that it shares about an investment opportunity. It reflects all the benefits of real estate investing like appreciation, tax benefits, amortization, and cash distributions. Any investor can get more detailed projections and more accurate snapshots of past performance by adding more variables to the equation.
Equity Multiple
While IRR measures the speed and liquidity in a complex manner, the equity multiple (EMx or EM) purely tells investors the value of their lifetime returns, by showing how much every dollar they invest could multiply over the lifetime of a project. An EMx of 2.0 would signify an investor doubling their money. You can find the equity multiple by dividing the cash distributions from the project by the equity investment.
Total Cash Distributions ÷ Equity Invested = Equity Multiple
One final time, let us analyze our inland apartment opportunity example. Based on the proposed cash flow schedule and internal rate of return, investors can expect an EMx of 3.85, which indicates every dollar they invest could be multiplied by 3.85 over the project lifetime. A ten-thousand-dollar investment would turn into $38,500 after ten years. Sounds enticing, right?
Best Financial Metric to Compare Investment Opportunities
While there are no “best” financial metrics to compare investment opportunities, each financial ratio is best at something.
- The capitalization rate is best at determining raw value and consistency.
- Cash-on-cash return is best at showing a single-year return on your investment based on financial strategies.
- Return on equity is the best for determining whether a project should remain a part of your portfolio or whether you should divest a project.
- The internal rate of return is best for comparing liquid and non-liquid investment returns and how quickly your capital grows.
- Equity multiple is best at demonstrating the lifetime returns of a single investment or a portfolio investment.
So, which metrics to compare investment opportunities should you use? You can use the financial metrics combination that best suit your financial goals. Real estate investing should be an individualized game. It is vital to align every strategic decision with your financial goals if you are to reach your full financial potential. Only after you understand should you choose which financial metrics suit your plan best and help you reach your goals.
For investing help, you can always reach out to us at invest@eikoninvestments.com.
Happy Growth.
