3 Key Metrics To Evaluating Deals + Their Hidden Drawbacks

[Justin Moy]

There are 3 key metrics we’ll dive into in this episode and I’ll review what they are and how they can be highlighted to downplay weak returns.

1: Cash On Cash

I wanted to start with cash on cash because it's likey a very common metric you've heard. You calculate cash on cash return by dividing the annual cashflow of a deal by the amount invested. So, if you invest $100,000 into an investment and get $7,000 in cash flow a year from it, your CoC is 7%. Pretty good deal in most markets.

Things to consider when evaluating CoC
Generally speaking most deals in terms of cash flow will be projected as an average annual cash flow.

So if you have a deal that’s projected to sell in 5 years and you invested $100,000 the deal can show a 7% cash return even if in theory it paid out 0 cash distributions but then paid you $35,000 in cash distributions year 5. Because that $35,000 divided by 5 years equals an average of 7% per year.

Now, it’s unlikely that there would be a scenario that extreme, but usually we don’t see an even cash flow in a property, if there’s a value add component to it it’s even possible there could be no cash flow in the first 1 or 2 years until the property is stabilized but always look out for the actual breakdown of when cash flow is paid out.

2: Equity Multiple

Equity is investor talk for cash, so think of this as a cash multiple. If you invest $100,000 into a deal and you get paid out $200,000 that’s a 2x equity multiple.

This multiple is broken down as a total return, so if that $200,000 payout can be part cash flow, part refinance, part sale of the property.

Things to consider when evaluating equity multiple:

They don’t account for time.

Let’s take a look at 2 deals as an example, both deals you’re planning on investing $100,000 in.

Deal A will sell in 5 years and make you $200,000. Deal B will sell in 10 years and make you $200,000.

By equity multiple, these 2 deals are equal. Both have a 2x equity multiple. But every investor would pick deal A over deal B, not just because of inflation making $200,000 worth less in 5 years versus 10, but because of the velocity of money. In deal A you get your cash back twice as fast and can now invest in more opportunities than if your cash was locked up for 10 years.

So although their equity multiple is the same, the actual desirability of the deals is substantially different.

3: Internal Rate of Return (IRR)

To calculate this formula you’ll want to use excel, don’t try to do it on your own, it’s an extremely sophisticated formula that most people wouldn’t know how to calculate.

What IRR does is assign time value to money. Just like in the previous example an IRR recognizes that deal A returns cash twice as fast as deal B and would assign a significantly higher IRR to that deal.

It also recognizes that cash returned earlier on in a deal is worth more than cash returned later, so it will also weigh distributions from cash flow sooner as more valuable than cash flow distributions later.

Things to consider when evaluating IRR

So you may think chasing a high IRR is a great metric that will always give you the best deal, but one thing many investors don't consider is chasing IRR tends to carry more risk.

To deliver a high IRR means things are moving quickly, and generally speaking deals with shorter terms are riskier than deals with longer terms, but the upside potential is also greater with your money being returned faster.

So, IRR tends to have a higher risk profile than other metrics.

There isn't a wrong metric to look at, every investor has different goals so if you lean on one that's fine, but we always recommend analyzing all the return metrics to create a full story of the property and strike a healthy balance between equity multiple, IRR, and cash returns.