When evaluating and analyzing real estate investment opportunities, there are three primary metrics usually highlighted in cash flow projections.
The internal rate of return or “IRR” is the average rate of return a project will generate over its lifetime, inclusive of all cash flow, refinancing and disposition proceeds.
The equity multiple or “EM” reflects the amount of money an investor gets back by the end of the deal. Simply put, if you put $200,000 into a property and eventually get back $400,000 the multiple is 2x.
When evaluating these ratios, one should be aware that such ratios do not guarantee the performance of a particular investment.
The technical definition of IRR is “the interest rate that makes net present value of all cash flow equal zero.” However, calculating IRR is a complicated process because it relies on forecasting future cash flows, which in turn can be affected by general market conditions, cap rates and other future events and assumptions.
IRR, however, can be materially affected by the duration of the hold. For example, a quick flip will likely have a significantly higher IRR than a 10 year hold; however, the whole dollars received by the investor will be materially less. In order to adjust for the fluctuations of IRR and time, investors should view the IRR in conjunction with EM, which looks at multiples of cash that are received over the holding period. Therefore, if a quick flip opportunity presented itself whereby an investor could invest $200.000 and post-flip would have $220,000 the investor might make a high IRR but the EM would be 1.10x and this investor would have to decide whether the risk warranted this 10% return.
The final metric in real estate terminology is the capitalization rate or “cap rate”. This is the percentage rate of return based upon the net operating income that the property is expected to generate. Cap rate is defined as net operating income divided by total value.
To illustrate the cap rate, assume $1,800,000 invested in a real estate property that generates net operating income of $125,000. The cap rate in this case is 6.94%. When cap rate goes down, the price goes up and when cap rate goes up, the price goes down. Using the same example, if the investor paid $1,500,000 the cap rate would be 8.33% and if the investor paid $2,000,000 the cap rate would be 6.25%.
