November 11, 2015
Over the last three months, “deal flow” has increased due to developers taking advantage of low interest rates. With this increased activity, various deals have emerged promoting different levels of return off of invested equity.
One deal prescribes their project at a 9.26% cap rate and it will generate a 9.15% cash-on-cash return; another promotes cash-on-cash returns of 8.57% and an internal rate of return (IRR) at16.33%; while another pushes a total return of 15.3% with an IRR at 15.9%. With so many different measurements of return, can you really compare each of these deals equally?
The simple answer is no. They are all projects in different markets, and all different product types, making them unrelated to one another for comparison. But it still begs the question – what is the difference in the various forms of measurements for rate of return? This is a key question, because as you’ll see below, not all rates of return are treated equally.
- Cap Rate is a term that always seems to get thrown around at cocktail parties and other social gatherings. “I have a property for sale that’s at a 9 Cap.” What is it? It is the net operating income (after expenses) of a property, divided by the market value of the property. The Cap Rate is a quick way for an investor to determine their potential return from a project. The questions that arise are; how is the NOI calculated and how is market value determined?
- Cash-on-Cash Return is a snapshot view of an investments performance over a certain year. The amounts used in the calculation are cumulative, and only one year is looked at. In this calculation, the cash return to the investor over a 12 month period, is divided by their equity investment. The idea of the time value of money is not considered, nor is the increase in property value. This method paints a broad picture, and will give an investor an idea of immediate return gratification, but it does not give you the true long term picture of the projects performance.
- Total Return on Investment provides a better picture of long term, overall investment performance. This calculation includes factors such as appreciation over time and future cash flows. This helps frame an investment over a period of time while looking at the future value of the property and future cash flows. With this model an investor is attempting to project what the value of their asset will be in 5-10 years, as well as what the cash flows will be off of that asset for a more accurate long term return projection.
- Internal Rate of Return (IRR) may be the most consistent measurement of return provided to investors. Some consider it to be more flexible as it considers multiple cash flows during various time periods; it can also be more complicated to calculate. IRR does not incorporate environmental factors, such as interest rate or inflation; rather it is a discount rate that makes the net present value of cash flow from a project equal to zero. It can be thought of as the rate of growth that a project is expected to generate.
With any investment, each investor needs to determine what their long term strategy is, and find the tools that are right for them to obtain their goals. All of these measurements are good bench marks to assist an investor in making an informed decision; ultimately it comes down to the property and its performance.
A savvy investor needs to monitor the market, ask good questions, and value the property accordingly. Returns should be analyzed annually; if they are not generating the returns you expect, then it is time to ask yourself why you are in the deal, and determine an exit strategy.