Let’s talk Return Metrics

[Bikran Sandhu]

Let’s talk Return Metrics...

There are four main return metrics in real estate deals: equity multiple,

average annual return (AAR), internal rate of return (IRR), and average

cash flow. In this post, I’ll start with explaining two of these

metrics: equity multiples and average cash flow.

What is average cash flow?

Average cash flow is equal to the total amount of money that is comes in or

leaves your bank account divided by your total investment divided by the

hold period.

For example, if you invest $100,000 into a real

estate deal, and receive $3,000 cash flow during the year, your average

cash flow is equal to 3% ($3,000 / $100,000) for that year. In the next

year, if you only receive $5,000 in total cash flows, your cash flow is

equal to 5% ($5,000 / $100,000) for that year. Therefore, your average

cash flow for the two-year period is equal to 4% (($3,000 + $5,000) /

$100,000) / 2 years.

What is an equity multiple?

An equity multiple is equal to the total proceeds received from a project divided

by the total equity that was invested in the project.

For example, let’s say you invest $100,000 into a multifamily project.

During the hold period, you receive $3,000 in year 1, $5,000 in year 2,

and $160,000 in year 3 on exit. In order to calculate the equity

multiple, you add all cash flows received from the investment and divide

it by the total cash invested. In this case, the equity multiple would

be equal to ($3,000 + $5,000 + $160,000) / $100,000 = 1.68x

Equity multiples are an easy way to evaluate a project but the issue with

equity multiples is that it does not consider the time it takes to

achieve that equity multiple.

For example, let’s say you are comparing two investments. Let’s also assume that the projects have

similar risk profiles (e.g., both are value-add, multifamily investments

with similar characteristics and location). In other words, the chances

of either project succeeding are equal.

Project A is expected to be held for three years. It requires a $100,000 investment on day 1.

You receive no cash flows until end of year 3. On sale, you receive

$168,000. Therefore, the equity multiple is 1.68x:

Project B is expected to be held for five years. It requires a $100,000 investment on

day 1. Through the hold period, you will receive yearly cash flows of

$5,000 per year for five years, and, at the end of the fifth year, you

receive $180,000. The total equity multiple for Project B is 2.00x.

What Project is Better? Project A or Project B?