Return Metrics
IRR, EM, CoC and the rest of the alphabet
Imagine this: you have 2 investment options. One is a stabilized core multifamily fund that generates 5% yield. The other option is a ground-up CRE development deal, that will generate no income until the property is leased up and sold in three years.
How do you compare the two?
Yes, we know they are on the opposite ranges of the risk scale. But in order to evaluate whether we are compensated sufficiently for the risk, we need to compare expected returns for each.
Today, we’re breaking down how common return metrics are calculated (and their limitations).
➡️ No single metric tells the whole story, so it’s important for investors to consider them together. You’ll also find a downloadable PDF guide at the end of this post.
We’ll cover this (and more):
Why hold duration matters when evaluating track records
How to properly calculate cash-on-cash
Why equity multiple needs to be taken into account
And which metric is the easiest to manipulate (yes, that one)
Internal Rate of Return (IRR)
One of the most widely used metrics in evaluating deal performance is Internal Rate of Return (IRR), so first let’s talk about what that actually is.
IRR is the discount rate that makes the net present value (NPV) of all cash flows equal to zero.
Why is it particularly useful? It takes into account all the cash flows received during the hold period, along with the timing of said cash flows.
However, this time-sensitive characteristic also becomes a drawback for this metric. It’s very easy to manipulate by throwing in early refinance assumptions with return of capital, or adjusting the hold period.
❗️Deals that provide higher cash flows earlier in the hold cycle will show higher IRR, even if the total returns in absolute dollars are lower.
Examples
Example 1: 5 Year Hold. Initial investment in Year 0 is $100,000. Cash flows from property operations start at $6,000 in Year 1, and grow at 5% every year. Net proceeds from sale to the investor are $150,000 at the end of Year 5 (investor also receives cash flow from operations in that year). Take a look at this table: