IRR

I will briefly mention why we use them, the pros and cons, and what to watch out for.

This is calculated by taking the cash distribution divided by the cash in the deal and averaging that out over each year of the deal.

Example:  You invest $100K, receive an $8K distribution year 1, $9K year 2, and $10K year 3.  Your returns over the years would be 8%, 9%, and 10% respectively and the average Cash on Cash comes in at 9%.  Pretty straightforward especially for deals that do not have any refinance or return of capital events.  Now, if a deal does have a return of capital events then this can get a bit tricky and a bit mis-leading.

Example:  Same scenario as before except at the end of year 3, beginning of year 4 there was a refinance event that returned 75% of your capital back to you.  The return for year 4 was $6K and for year 5 was $8K.  Because of the refinance event, you only have $25K left in the deal yielding a cash-on-cash return of 24% year 4 and 32% year 5, creating an overall average cash-on-cash return of 16.6%.  That’s a pretty great return but it definitely feels skewed a bit.  Any error in the projections (good or bad) could drastically increase or decrease the CoC return after the refinance which doesn’t make this the best metric to use necessarily all the time (i.e. a $2K miss is only a 2% cash-on-cash decrease before the refinance but an 8% decrease after).

So what is ideal and what do you want to see? 

Ideally you want to see a fairly strong cash-on-cash early in the deal as this lowers the overall risk of the investment because unless projections are way off, that cash-on-cash should be more stable.  Note:  A low average cash-on-cash return with a high total return on investment and internal rate of return generally means most of the returns will come from the exit of the investment.  That means there is more risk in the investment as who knows what is going to happen between now and five, seven, even ten years down the road.  A good rule of thumb is you want a good amount of the total return to be from cash on cash as that means the investment has lower overall risk.

The next metric to discuss is the Total Return on Investment. 

This metric is simply telling you how much money you receive back during the life of the investment.  I.e. if you invested $50K and received $100K back your total return on investment would be 100%.  By itself, this metric isn’t very useful as it doesn’t give good insight on the risk of the investment nor what strategy is being used.  Combined with the IRR and CoC it allows you to determine if either of those are misleadingly due to a high return of capital event.  In a “straight” deal with no refinance event this will tell you the total return to expect after the set hold time but it does not account for time in the deal.  In other words, this metric may tell you your money will double but at a glance it won’t tell you if that will happen in 3 years or 10 years.

So what is ideal and what do you want to see? 

Ideally you want to see a fairly strong cash-on-cash early in the deal as this lowers the overall risk of the investment because unless projections are way off, that cash-on-cash should be more stable.  Note:  A low average cash-on-cash return with a high total return on investment and internal rate of return generally means most of the returns will come from the exit of the investment.  That means there is more risk in the investment as who knows what is going to happen between now and five, seven, even ten years down the road.  A good rule of thumb is you want a good amount of the total return to be from cash on cash as that means the investment has lower overall risk.

The next metric to discuss is the Total Return on Investment. 

This metric is simply telling you how much money you receive back during the life of the investment.  I.e. if you invested $50K and received $100K back your total return on investment would be 100%.  By itself, this metric isn’t very useful as it doesn’t give good insight on the risk of the investment nor what strategy is being used.  Combined with the IRR and CoC it allows you to determine if either of those are misleadingly due to a high return of capital event.  In a “straight” deal with no refinance event this will tell you the total return to expect after the set hold time but it does not account for time in the deal.  In other words, this metric may tell you your money will double but at a glance it won’t tell you if that will happen in 3 years or 10 years.

The final metric to discuss and is my personal favorite, the Average Internal Rate of Return. 

The average internal rate of return is shown as the interest yield as a percentage expected from an investment and helps us capture distributions throughout the years as well as the time value of money.  This is good because a distribution in year 1 is worth more than a distribution in year 5 of the same amount (due to the time value of money).  If we factor that into the equation it helps us make good comparisons for various opportunities.  See the examples below:

In these examples you can see that all investments have the same Total Return on Investment as well as Average Cash on Cash Return, however, they each have a different Average IRR.  You can clearly see the benefit to IRR from receiving cash earlier on in a deal vs later.  The sooner you get the money back the sooner you can put it back to work for you.

If you would like to learn more about Multifamily Real Estate and how to invest, please email me directly at James@jcoreinvestments.com