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For commercial real estate investors, understanding key financial metrics is crucial to assess potential investments accurately and make informed decisions. There are many financial and investment metrics that savvy commercial real estate investors evaluate when buying and selling properties. Here are five key metrics that every real estate investor must know when investing: 1. Internal Rate of Return (IRR) 2. Cash on Cash Return 3. Equity Multiple 4. Capitalization Rate (Cap Rate) 5. Debt Service Coverage Ratio (DSCR). Let’s explore each financial metric so that you understand what they mean and how you can use them in your current or future real estate investment portfolio:
The Internal Rate of Return (IRR) evaluates the profitability of potential and existing investments. IRR represents the annualized effective compounded rate of return based on the sum of discounted cash flow over a specified period such as five or 10 years. Unlike Return on Investment (ROI), IRR is impacted by the time value of money. If you have two investments with the same total cash flows and same sale price, and one property sells after five years and one property sells after 10 years, the property that sells after five years will have a higher IRR compared to the property that sells after 10 years. IRR is a helpful metric to compare properties, particularly when comparing investment returns over time. While a higher IRR may indicate a more profitable investment, an investor should understand the underlying assumptions and the project level risk.
Cash on cash return measures the cash income earned on a commercial real estate investment relative to the cash invested in a property. To calculate cash on cash return, an investor divides the annual pre-tax cash flow by the total amount of cash invested. Cash on cash return can give investors a quick snapshot of their investment’s cash yield in a specific year. Importantly, cash on cash return focuses purely on cash flow. Therefore, cash on cash return measures only the return on the actual cash invested and does not account for any financing used. Also, property appreciation and debt payments are not reflected in the cash on cash return formula, since only cash is what matters.
An equity multiple measures the relationship between cash distributions and the equity invested. So, an investor uses an equity multiple to measure the total cash return earned over the lifespan of the investment based on the initial equity investment. To calculate an equity multiple, an investor divides the total cash distributions received from an investment, including the sale proceeds, by the total equity invested. An equity multiple greater than 1.0x means an investor receives a positive return compared to the initial investment, whereas an equity multiple less than 1.0x means an investor receives less than invested. While an equity multiple tells an investor how much an investor earns from an absolute return perspective, an equity multiple doesn’t indicate how long it took to earn that return. For example, a multiple of 2.5x earned over 10 years or 20 years would still be the same. In contrast, the IRR would be different, since IRR is impacted by the time value of money.
A capitalization rate, or Cap Rate, helps investors evaluate a commercial real estate property’s rate of return in a single year. To calculate Cap Rate, divide the property’s net operating income (NOI) by its current market value. A higher Cap Rate implies a potentially higher return on investment but usually comes with higher risk because an investor has to be compensated for the higher return. A lower Cap Rate implies a lower rate of return but generally more stable cash flow. Cap Rates are used to make quick comparisons among investment properties and are used to assess the market’s indicator of risk. Importantly, cap rates don’t consider the impact of debt on a company, including interest payments or amount of leverage; cap rates only focus on NOI. The going-in Cap Rate is the projected first year NOI divided by the purchase price. Typically, the exit Cap Rate is used to estimate the sale price based on the projected exit year NOI.
The Debt Service Coverage Ratio (DSCR) measures a property’s ability to cover its debt payments based on its net operating income. To calculate DSCR, an investor divides the NOI by the total debt service. A DSCR greater 1 means the property generates enough cash to cover its debt payments. A DSCR less than 1 means the property doesn’t generate enough cash to meets its debt payments. Lenders prefer a higher DSCR to lower the likelihood of a default or foreclosure.
Understanding these five key metrics—IRR, Cash on Cash Return, Equity Multiple, Cap Rate, and DSCR—is essential for any commercial real estate investor. While these aren’t the only important financial metrics, these metrics are helpful to investors to analyze investment opportunities and evaluate properties to ensure good decision-making and better overall investments.
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