Let’s cover off two other private real estate return metrics, after looking at IRR from our last blog:
1. Cash-on-Cash Return
The formula for CoC = (Annual net cashflow, before income tax) / (Total Cash Invested). CoC is usually represented in percentage.
In the case of residential scenario, it would be a fraction where the numerator is annual gross rents collected after deducting (i) recurring fees & expenses (such as PM, taxes & insurance, HOA for condos), (ii) mortgage (if there’s financing), (iii) any capex, cost related to vacancy, and maintenance; the denominator is sum of your down payment & other out-of-pocket closing costs (such as appraisal, property inspection fees, bank charges, legal, title).
In the case of investments in CRE syndication, the numerator is the sum of the annual actual cash distributions made to the LP investor, while the denominator is the LP’s investment. Simple enough. Assuming the LP puts in an investment of $50K into a syndication that pays an annual preferred return of 8% and that investment distributes monthly and everything goes according to plan, that investor gets a monthly payment of $50K x 8% / 12 = ~$333 pre-tax. Simple enough.
It’s worth noting that cash-on-cash return on some heavy repositioning/value-add deals could be way less than the stated preferred returns, especially in the earlier months/years of the deals where most cash are used to implement the business plan (upgrade, build-out, improve, lease-up, etc.), leaving little to no cash for distribution. If the preferred return are cumulative per the operating agreement, then the unpaid portion will be made up to the investors in subsequent period(s); if preferred returns are non-cumulative, then they won’ be. Cash-on-cash returns that I’ve come across capture available cash for distribution from operations and do not take into account distribution of proceeds from sale or refinance (commonly known as capital events).
2. Equity Multiple (EM), a cousin of ROI
EM is a fraction where the numerator is the sum of “return on, and return of principal” so in effect the return of your cumulative investment plus any and all cumulative return thereon, while the denominator is investor’s total investment. Formula for ROI is (Gain – Cost / Cost); here I use investment and cost interchangeably).
Since rule#1 of any investment is not to lose money, you want your EM to be > 1. An investment of 1 means you just get your original investment back. An EM of 1.9x means after getting your “principal” back, you earned extra 90%. In calculating EM, the numerator includes all the periodic distributions made throughout the hold period plus the final payout from capital event (sale or refinance).
EM, as with ROI, doesn’t shed light on the timing of the returns – by that I mean how long it takes to produce those returns, how frequent those returns come in, whether they kick in earlier in the years, distributed somewhat evenly or roll in lumpy at the end. Needless to say the shorter it takes for returns to kick in, the better it is, ceteris paribus. But I guess some people are fine with later-year distributions, if they are already cash-rich from their other investments. The point is that while a 3x or 4x EM looks impressive but if it takes 10 years to get there you might want to reconsider. The longer the time horizon of an investment, the more variables are at play; this introduces uncertainties and uncertainties mean risks. Ergo in displaying EMs as part of their track records or in projections, sponsors often accompany EMs with holding periods to show in what period of time (months or years) were/are the EMs achieved, or expected to be achieved.
An EM < 1 means not only do you not earn any return on your money, you don’t even get your principal back. This reminds me of an investment that most Americans are forced to partake, the Social Security, otherwise known as So-So Security or the lack of Security, sponsored by Uncle Sam. What am I getting when I retire, assuming it hasn’t gone bust by then?!?! How the SEC turns a blind eye to this ponzi scheme and let it continue is beyond me. Can I redeem out of it please?
From a LP perspective, looking at a few of these return metrics such as CoC, IRR, EM, ROI, in conjunction of expected hold period rather than focusing on a single metric helps you get a better feel if an investment meets your criteria. Most sponsors/syndicators present a combination of these metrics.