As we’ve discussed in other articles, when purchasing apartment buildings, there is normally two types of partners involved:
- A general partner or partners (syndicators)
- Limited partners (investors)
There is a variety of structures on how limited partners can get paid. Some of these are:
- A fixed preferred return
- A share of the profits from the rents and the sale of the building
- A combination of the two approaches above
- Other creative approaches
Independently of the approach chosen, there are certain metrics that each potential investor should be familiar with. Some of these are discussed in the following sections.
Internal rate of return
Internal rate of return or IRR, is a financial metric that estimates the total profitability of investments. It can help calculate the annual return for an investment in 1 year, 10 years, or even 50 years.
The higher the estimated IRR, the better, in terms of cash flow.
IRR formula
NPV = Net present value
n = Non-negative integer
N = Total number of periods
C(n) = Cash flow
r = Discount rate
To calculate IRR using this formula, NPV must be equal to zero and the goal is to must solve for r. The software program Excel makes it easy to find your IRR.
Net present value
Net present value also called NPV, is used to analyze the return of an investment. It is calculated by taking the difference between the current value of cash inflows and current value of cash outflows over a certain period of time. The main idea of NPV is that a dollar in the future is not as valuable as a dollar today. This is because money loses it’s value over time because of inflation.
When NPV is positive, a project will generally be profitable while a negative NPV represents a net loss.
NPV = Today’s Value of The Expected Cash Flows – Today’s Value of Invested Cash
Cash on cash (CoC)
Cash on cash return, is a rate of return that estimates the profit earned on the money invested in a property. It measures the annual return that an investor made. Unlike IRR, cash on cash may not span multiple years. It usually only measures the profit for one year.
The formula for cash on cash return is as follows:
Cash on cash = Annual Cash Flow / Total Cash Invested
Annual Cash Flow = (Gross Scheduled Rent + Other Income) – (Vacancy + Operating Expenses + Annual Mortgage Payments)
What is equity multiple?
Equity multiple is a real estate metric that helps to calculate the estimated total profits from an investment. To calculate it, you must divide the total amount of money earned by the total amount of money invested.
Equity Multiple = Total Distributions / Total Invested
Examples:
- An investor buys a property for $200,000. This property pays $10,000 a year in NOI. The investor then sells the property for $250,000 in 3 years. $10,000 per year for three years plus $250,000 is equivalent to $280,000. So now, lets calculate the CoC:
$280,000 / $200,000 = 1.4 (equity multiple)
- An investor buys a property for $300,000. The investor then sells the property in 10 years for $600,000. But the investor only receives $510,000.
$510,000 / $300,000 = 1.7 (equity multiple)
In conclusion, investments in different asset classes may require different due diligence techniques, but the formulas that we have laid out in this article will serve you well when analyzing investments across many different asset classes.