Fundamentals of Multifamily Investing
What is a capitalization (cap) rate?
A cap rate is a calculation of the existing income of a property relative to its value (price). A cap rate is calculated by dividing net operating income (NOI) by price. The higher the cap rate, the more income a property has relative to its value, which makes for more attractive cash flows. Typically, properties which have the potential to increase NOI and value, will sell for a lower cap rate. Conversely, properties with no value-add potential, must sell for a higher cap rate as these are considered to be “yield plays”, or investment strategies focused on cash flow. Lastly, nicer properties and superior locations garner a higher price, which in turn results in a lower cap rate.
What are internal rate of return (IRR), cash on cash (CoC), and equity multiple (EM)?
The return metrics referenced above are the most important metrics investors should focus on. IRR is a sophisticated calculation of all projected cash flows, typically using Microsoft Excel. IRR is most similar to Average Annual Returns except that it takes into account the compounded time value of money.
Cash on cash is a simple annualized calculation of cash distributed divided by cash invested. For example, if an investor who contributed $100,000 receives a $2,000 distribution for a quarter, their annualized cash on cash would be 8% ($2,000*4 / $100,000).
Equity Multiple calculates the total profit made or projected to be made from the investment, irrespective of time. For example, if a $100,000 investment is projected to generate $100,000 of profit in 5 years, the equity multiple would be 2.0x ($100,000 to $200,000). The downside of equity multiple is that it does not factor in time. Therefore, just knowing the equity multiple of an investment without timeline is not very helpful.
What is a preferred return?
A preferred return is a common feature of a real estate partnership structure whereby an investor’s return is put in first priority prior to any sponsor/manager participation in the profits or performance compensation. For example, investors may receive an 8% preferred return which entitles investors to a minimum of an 8% annualized, compounding return prior to the sponsor (Lone Star Capital) receiving any performance compensation.
[VIDEO] The Nuances of Preferred Return
What are risk-adjusted returns?
A risk-adjusted return is a subjective measure that puts returns into context based on the amount of risk involved in an investment. This is an advanced topic as most investors have a difficult time understanding and gauging risk as it relates to real estate investments. Furthermore, based on certain expert opinion, risk is impossible to quantify, making the rationalization of risk-adjusted returns even more difficult. Generally speaking, the higher the potential risk of a project, the higher the projected return should be. Conversely, if an investment’s business plan and income stream is secure, lower return hurdles should be considered as appropriate.