All Forum Posts by: Wayne Courreges III

In a previous blog we looked at "cash-on-cash" returns to provide a good measure of immediate and ongoing annual returns an investor can expect. However, this metric did not take into account an important element...time. The Internal Rate of Return (IRR) uses the time value of money to better analyze the investment opportunity. This metric is important since a dollar today is worth more than a dollar tomorrow due to inflation, opportunity cost, and risk.

So, what is IRR? IRR is defined as a discount rate that makes the net present value (NPV) of all cash flows from a particular project equal to zero. I will spare you from the formula and calculation, however, Excel’s IRR function will easily compute your IRR on your next investment opportunity.

To keep it simple, let's look at the scenarios below comparing 4 different investment opportunities. Each investment opportunity has an initial investment of $50,000 and cash flows differently for years 1-4. At year 5, the scenarios assume the same sales price for each investment. With each scenario you will see a different profit and IRR. If you are more concerned with consistent cash flow you may decide to go with scenario B, despite a lower overall IRR. However, if you are looking to maximize returns you would likely choose scenario C.

There are three things to consider when evaluating a "good" IRR for your own specific needs.

1. Despite there not being a one size fits all for each multi-family asset class, there are general assumptions on what an asset class can expect for an Internal Rate of Return. With any investment, your returns are directly related to the risk involved with the property as indicated below.
   1. Core: 8%-12% IRR
   2. Value-Add: 12%-18% IRR
   3. Opportunistic: 18%+ IRR

1. IRR will change based on the time it takes you to receive your investment back. A faster return on investment will yield a higher IRR since the metric is computing the time value of money. Another way to look at it is the longer the opportunity takes to receive your investment the less valuable it is.

1. You should never solely rely on IRR when evaluating an investment. While IRR is the "measuring stick" for private investments, it does have some limitations. Investors need to realize the difference between IRR and annualized returns, in order to make smart investments and real estate decisions. When calculating IRR it is assumed all distributions will be reinvested immediately, which means there is a built-in compounding assumption that actually doesn't happen.

There is obviously a lot to consider when investing in a property. Knowing all the tools available is crucial to making a good investment. There probably isn’t one perfect calculation, however, educating yourself with all the options and using multiple calculations will ensure you the most accurate evaluation for your investment.

Bryan- Great points on the 506(b) and 506(c) offerings.  You make an interesting point on the industry missing marketing processes to assist new sponsors raise capital.  I will work on doing a blog in the future about this!  Separately, I would enjoy connecting as I am in the Austin area as well.  Stay well!

There are two primary financial metrics when evaluating a multi-family investment opportunity. The first is Cash on Cash (CoC) and the other is Internal Rate of Return (IRR). Most non-real estate investors will seek to understand the return on investment (ROI) to evaluate the deal, however, ROI metrics will not work in analyzing real estate. In the world of real estate, Cash on Cash and IRR are the easiest metrics to evaluate an opportunity since you do not know how much profit you will make before selling the property, which is needed to determine the return on investment.

Let’s dig more into Cash on Cash Returns.

Cash on Cash is a rate of return calculated by dividing the pre-tax cash flow produced by the property, by the initial cash investment. This rate of return can also be called the cash yield and equity dividend rate.

Cash on Cash Formula: Annual Pre-Tax Cash Flow / Total Cash Invested

Cash on Cash gives a good feel for the immediate and ongoing annual return that a cash flow investor can expect. When evaluating a multi-family investment opportunity, the sponsor will provide annual CoC projections. If the property is a deep value add or opportunistic investment you may not see immediate Cash on Cash returns until the property is stabilized. You will likely see most of your returns at refinance or sell in this scenario.

CoC is an important step for an investor to measure property profitability. Notice the Cash on Cash return is based on pre-tax. If you are already experiencing low returns, the taxes may wipe out any potential returns on investment.

Cash on Cash Returns Scenario:

The purchase price of an apartment building is $6,400,000. The deal sponsor pays 20% of the total loan as a downpayment, or $1,280,000, and takes a mortgage in the amount of $5,120,000. In addition to the down payment, the sponsor puts aside money for capital expenses in the amount of $520,000 making the total cash invested at $1,800,000.

Year one total projected revenues is $962,326. The operating expenses for year one is $510,909, making the Net Operating Income ($962,326 – $510,909) equal $451,417.

You will then deduct mortgage principal and interest from the Net Operating Income. For our scenario, the principal and interest is $317,544, making the total annual pre-tax cash flow equal $133,873 ($451,417 – $317,544).

Lastly, divide the annual pre-tax cash flow ($133,873) by total cash invested ($1,800,000) to get the Cash on Cash return of 7.44%.

What is a good Cash on Cash Return? Prior to Covid-19 the typical CoC returns were 8% to 12%. In today's environment a Cash on Cash of 6% to 8% may be more acceptable. Especially as most alternative investments are providing zero returns, and some investments are going negative as we see in our 401k and stock investment portfolios. In the case of the scenario above the 7.44% annual return is attractive in today's environment.

In the past, one of the primary ways private companies raised funds for real estate investing was through Rule 506 of Regulation D. Regulation D is an exemption from registering securities with the Securities and Exchange Commission (SEC). When Title II of the Jump Start Our Business Startups (JOBS) Act took effect in September 2013, Rule 506 of Regulation D was split into 2 separate exemptions, 506(b) and 506(c).

The 506(c) plan permits issuers to solicit and advertise an offering, similar to crowd funding with restrictions. Purchasers must be accredited investors. Issuers must take steps to verify purchasers “accredited investor status” and determine they meet other conditions in Regulation D. An accredited investor is an individual who qualifies to invest in real estate syndications by satisfying one of the following requirements: an annual income of $200,000—or $300,000 for joint income—or a net worth of at least $1 million (not including primary residence). More information by the SEC click here.

Some benefits to 506(c) plan:

• Businesses have more flexibility in raising capital. They are permitted to publicly advertise in a cost-effective manner.
• Business are permitted to use social media and other advertising techniques reaching a much broader group of investors.
• Businesses have the freedom in making disclosures to investors which can enhance an investors interest in investing, likely to solidify more deals for the business owner.
• Financial statements produced by the business for investors do not need to be reviewed or audited by an independent accountant. Making for less steps and an easier deal.
• No limit to the amount of capital that can be raised.
• The issuer or broker-dealer has to verify the accreditation status of the investor. Accreditation is achieved by either proving the investor has a net worth of $1,000,000 not including primary residence; by proving that the investor has made $200,000 a year over the past 2 years, with a reasonable prediction to make that again this year; or by a letter of accreditation by a CPA, attorney, or other professional. So thorough background checks ensure a safe deal for the issuer.
• No document disclosure requirements because all investors must be accredited and theoretically should know the right questions to ask before they invest, making it easier to manage the deal.
• No waiting period requirement as with the 506(b) plan.

Now that we’ve covered what the 506(c) plan is and its benefits, let’s take a look at the three main differences between the 506(b) and 506(c) plans:

• 506(b) markets directly to deal sponsors network without general or internet solicitation. This is not an issue with 506(c), the possibilities for investors are endless.
• 506(b) only up to 35 non-accredited investors are permitted to invest and no limits on accredited investors. 506(c) only accredited investors that show they understand the investment may invest.
• 506(b) accredited investors typically self-certify while 506(c) issuers rely on various methods to verify accredited status.

Like everything else, the investment arena is always evolving. These days there are more options to raising capital than ever before. The key is knowing all your options, do your research and find what is best for you personally and professionally.