Whenever you look at a real estate investment opportunity, there are lots of terms to consider when weighing up how solid that deal is.
But which metrics really matter?
And what does all that jargon mean?
Let’s cut through the overwhelm with some simple definitions.
But before you dive into analyzing or comparing any metrics, here’s a really important point to get straight.
Always Question The Assumptions
Blind faith is a terrible recipe for making effective investments. Even though syndications are passive investments, you still need to be a critical thinker and do your due diligence.
Any time you look at the metrics below — or really anything else to do with investing — always ask this:
“How was this information produced and how reliable is it?”
Think about it: we don’t have perfect knowledge of the future, so everything we do in investing is based on assumptions. We must ask ourselves how watertight those assumptions are instead of just trusting a number presented on a deal.
The quality of the assumptions depends in large part on who is presenting the deal.
An ethical sponsor who knows the market and who digs into the fine detail of every aspect of a deal before offering it to their investors is not the same as a guy selling a shady deal for a quick buck.
Put another way, you need a sponsor you can trust, with a solid track record of operating successful passive investment deals.
Top Investment Deal Metrics
ROI (Return on Investment): A measurement of how much profit is made over the entire lifetime of an investment. This is the term most people have heard of and is basically the total amount you get back from an investment. It does not take into account the length of time your money is invested.
Equity Multiple: This is the same as ROI but in decimal format. If you double your money, that’s a 2.0 equity multiple. This can be less confusing than talking about a “100% return” for example.
Cash-on-Cash Return: The annual return, based on the amount of cash that was invested in a deal. For example, let’s say you buy a $60,000 house and you use $20,000 in cash for down payment and closing costs and you get a mortgage for the rest. If the property gives you $2,000 of positive cash flow each year, that would be a 10% Cash-on-Cash return. ($2,000 / $20,000 = 10%)
IRR (Internal Rate of Return): While the ROI relates to the total return, the IRR measures the rate of that return. If you have two deals that give you the same ROI but one of the deals pays back more of its return early on, that deal will have a higher IRR. With a higher IRR you get more of your money back sooner, which you can use for other investments, thereby increasing your overall returns. Consider that due to inflation receiving money down the road is less valuable than money that you can use now – so deals with a higher IRR are preferable.
Cap Rate (Capitalization Rate): This lets you compare multiple real estate deals under the same terms, as though the properties were bought on an all-cash basis. This is the best way of making an “apples to apples” comparison of deals regardless of the financing involved. Assumptions for Cap Rates when exiting a deal can have a dramatic impact on the deal’s total return.
If you want chapter and verse on these metrics, then my book, Backstage Guide To Real Estate, will help.
Other Important Considerations
While the following items aren’t metrics in the same way as those above, they’re still important considerations to be aware of when assessing whether a deal is right for you.
Financing: How a property is financed can have a massive impact on both the returns and level of risk on a deal. How much of the property will be financed? What is the length of the financing? Is the interest rate floating or fixed? While refinancing can be a great thing, I stay away from deals that show a refinance of mythical proportions.
Return on capital versus return of capital: I covered this when we looked at how passive investors make their returns. Briefly, return on capital is where returns are received by the investor but are not deducted from their capital contribution. Return of capital is where returns are received by the investor and are deducted from their capital contribution.
Depreciation: This is the reduction in the value of a property over time due to wear and tear on the asset. Different assets have different depreciation rates, and you can’t always take full advantage of the benefits of depreciation, so be careful with assumptions about how appealing a deal looks. Take a look at how real estate depreciation works for more on this.
Join Me Backstage
I present investors with offers that are transparent, so they can understand all the assumptions we use to determine the metrics we present. Learn more and get involved by joining the Picheny Investors Club.