The 4 Most Common Metrics Used To Measure A Deal

[Justin Moy]

There are 4 common metrics you’ll see when evaluating deals as a passive investor:

1 - Cash on cash return: This is what most people think about when investing in real estate.

Cash on cash is measured by how much rental income you get for the money you put in. If you put in $100,000 into a deal and get $5,000 per year in rental income, your cash on cash return is 5%.

The amount of cash return you’d typically look for in a deal depends on the strategy, but many aim to achieve at least 5% on average through the lifetime of the deal. Meaning if you buy into a heavy value add deal you may get 0 or 1% the first year as you rehab and stabilize the property, but then as you push up rents you start to see 4% then 5%, then 6%+ and the average over the 5 years of the property ends up being 5% or a bit more.

Some deals like in the development space may offer 0% cash on cash but they have high non cash return metrics that we’ll dive into in a bit.

2 - Average annual return: If you put that same $100,000 into a real estate deal and over 5 years you receive $200,000 in total cash by the time the deal is sold, you received an average annual return of 20%.

Average annual return is a mixture of all the cash you’ve received. Most of this return will be seen at the end of the transaction when you sell the deal, but if you put in $100,000 and get $200,000 over the next 5 years, that means you had $100,000 in profit.

That profit could be broken down as $20,000 in cash flow through rents, then $80,000 at the sale of the deal.

I’d say most people look for deals that project at least a 15% Average Annual Return.

Meaning your average return doesn’t exactly come in in equal amounts throughout the year. A big chunk of that return is typically coming at sale or refinance of the property.

3 - Equity multiple: Equity is a fancy word for cash, if you put in $100,000 into a real estate deal you’ve put in $100,000 of equity.

Equity multiple projects how much you’ll multiply that investment by over the life of the deal. In this same example where you put in $100,000 and get $200,000 from start to finish of the deal, your equity multiple is 2.0.

When looking at equity multiple it’s important to understand it does not take into account the timing of a deal. A deal that has a 2.0 equity multiple over a 5 year period is providing way more return than a deal that has a 2.0 equity multiple over a 10 year period.

Both deals will double your investment, but one does it in half the time, so your return is significantly higher in that deal.

How much equity multiple you look for will depend on the duration of the investment.

4 - Internal rate of return (IRR): IRR is a complex formula that almost everybody will need a computer to calculate for them.

IRR adds the time value of money into the equation, since money today is more valuable than money tomorrow, it weighs when you receive returns in addition to how much those returns are.

Let's say you have 2 deals and both are 5 year deals, and both project to turn your $100,000 investment into $200,000. Meaning both have a 20% average annual return, and a 2.0 equity multiple.

But the first deal is a development deal, which means it will take 5 years to construct and during that 5 years you’ll have no cash flow, all your return comes when the deal is sold.

The second deal is a value add deal that has some cash flow throughout the years.
IRR will show that second deal as being more valuable because as an investor you’re getting some of that cash in year 1 through 5 as opposed to having to wait entirely until year 5 to see any cash.

Since inflation makes cash less valuable in the future and cash now can be reinvested, IRR favors the deal that gives you cash more quickly.

When evaluating deals you have to understand what your individual goals are. Some people lean entirely on cash flow and cash returns while others may want to build massive wealth through high IRR and equity multiple deals. Finding your investing strategy is the first step to determining which metric you place the most weight on.