Investing in multifamily real estate can be a game-changer for your financial future, offering the potential for steady cash flow and long-term appreciation. But how do you know if a deal is truly lucrative? The secret lies in understanding three powerful metrics: Cash-on-Cash Return (CoC), Internal Rate of Return (IRR), and Annualized Rate of Return (ARR). These metrics are like the compass guiding you through the complex landscape of real estate investing, helping you make informed decisions and maximize your returns. As you dive into the world of multifamily investments, you might find yourself asking, “What do these metrics really mean?” You’re going to need to put some time and effort into understanding these metrics, though. The Dread Pirate Roberts had it right: “Life is pain, Highness. Anyone who says differently is selling something.” Anyone who tells you, “just trust me,” “it’s a sure thing,” or some other statement telling you that you have no responsibility to evaluate the deal is absolutely prioritizing the sale of your well-being.
What do the three metrics—Cash-on-Cash Return, IRR, and ARR—mean in multifamily investing?
Cash-on-Cash Return measures annual cash flow relative to the initial investment, focusing on immediate returns. IRR evaluates overall profitability by considering future cash flows and the time value of money. ARR provides a simplified annual return rate, excluding time value.
Cash-on-Cash Return (CoC)
Cash-on-Cash Return (CoC) is a straightforward metric that provides insight into the annual return on the cash you invested in a property. It is calculated by dividing the annual net cash flow—essentially, the rental income minus operating expenses—by the total cash invested, which includes the down payment, renovation costs, and other fees. CoC gives you a snapshot of your yearly return on investment (ROI). However, it doesn’t account for appreciation or the proceeds from a future sale. To quote Prince Humperdinck’s warning in the Princess Bride, if you don’t understand how CoC works, you’ll be headed “straight for the Fire Swamp!” Without grasping this metric, it’s hard to avoid potential pitfalls in your multifamily investment journey.
Example #1
Imagine you invest $100,000 in a property that generates $10,000 in net cash flow annually. Your CoC is 10,000 ÷ 100,000 = 10%. It’s a sweet deal, but remember, it doesn’t include the chocolatey goodness of future profits from selling the property.
Example #2
Now, suppose you make a smaller initial investment of $50,000 in a property that generates $5,000 in net cash flow every year for five years. In this example, the Cash-on-Cash Return (CoC) remains at 10% each year. This is because CoC is calculated annually by dividing the net cash flow by the initial investment, and in this case, the calculation is 5,000 50,000=10%50,0005,000=10% each year
Internal Rate of Return (IRR)
The Internal Rate of Return (IRR) is a more complex metric that considers the time value of money, offering a comprehensive view of an investment’s profitability over its holding period. It’s like Doc’s “time-traveling” DeLorean of investment returns, taking into account the time value of money.
Unlike CoC, IRR takes into account future cash flows, appreciation, and the eventual sale of the property. It calculates a single discount rate that equates the present value of these cash flows to your initial investment. While it requires a calculator or software to compute, IRR provides a deeper understanding of how quickly your investment is growing, helping you make informed decisions. For this reason, resonsible apartment syndicators have the projected IRR available for any deal they present to their potential investors.
Example #1
Imagine you are part of a group of investors who collectively contribute 35% of the $12 million purchase price for a multifamily property, resulting in an initial investment of $4.2 million. Your share of this investment is $100,000. Over five years, you receive $10,000 annually in net cash flow. At the end of Year 5, the property is sold for $14 million, thanks to successful value-add opportunities. Your portion of the sale proceeds is roughly $117,000. The Internal Rate of Return (IRR) would be the rate that equates the present value of these cash flows and sale proceeds to your initial $100,000 investment, or approximately 14%. Calculating IRR requires a financial calculator or software, but it effectively measures how quickly your investment is growing over time.
Example #2
Now, suppose you invest $50,000 in a multifamily property, generating $5,000 in net cash flow annually over five years. At the end of Year 5, you sell the property for $67,000. This results in a total return of $92,000, combining both the cash flows and the sale proceeds. Achieving this outcome would reflect an Internal Rate of Return (IRR) of 15%, illustrating how IRR accounts for the time value of money and provides a comprehensive view of the investment’s profitability.
Annualized Rate of Return (ARR)
The Annualized Rate of Return (ARR) offers a simplified approach to evaluating an investment’s performance by calculating the average annual return over the investment period. ARR is determined by considering the total net cash flow and profit at sale, divided by the total cash invested and the number of years of ownership. While ARR provides a quick and straightforward assessment, it does not account for the time value of money or depreciation, which can be significant factors in real estate investing.
ARR is particularly useful for investors who want a high-level overview of their investment’s performance without delving into more complex calculations. However, it’s important to remember that ARR can sometimes paint an incomplete picture, as it treats all cash flows equally regardless of when they occur. The ARR can be a quick and easy metric to give you an idea of the value of the investment, but it can also be misleading if the investment involves significant cash flows at different times, especially for investments that hold the capital for more than a couple of years.
Example #1
In this example, you invest $50,000 as part of a group contributing 35% of a multifamily property’s total purchase price of $4,000,000. Over a five-year investment period, to achieve an Annualized Rate of Return (ARR) of 15%, your total return needs to amount to $87,500. This includes $7,500 in annual returns, totaling $37,500 over five years, plus your initial investment of $50,000. Therefore, the combination of annual cash flows and sale proceeds should equal $87,500 to meet the target ARR.
Example #2
In the second example, you invest $100,000 as part of a group contributing 35% of a multifamily property’s total purchase price of $12,000,000. Over the same five-year investment period, to achieve an ARR of 14%, your total return must reach $170,000. This consists of $14,000 in annual returns, totaling $70,000 over five years, in addition to your initial investment of $100,000. Thus, the total of annual cash flows and sale proceeds should amount to $170,000 to achieve the desired ARR.
Choosing the Right Metric
Choosing between CoC, IRR, and ARR depends on your investment goals. If you’re focused on annual cash flow, CoC might be your go-to. For a comprehensive view that includes future profits, IRR is your best bet. ARR offers a quick, simplified assessment but lacks the depth of IRR. Remember that no single metric should dictate your decision. Use them in tandem to get a full picture of your investment’s potential.
Final Thoughts
Investing in multifamily real estate is like a box of chocolates—you never know what you’re gonna get, but with the right metrics, you can make a more informed choice. Keep these metrics in your investment toolbox, and you’ll be well on your way to evaluating deals like a pro. When you have questions about these metrics and analyzing multifamily property deals, please reach out to TAWC Properties.
Related Questions
How do these metrics change with different investment strategies?
Different strategies affect metrics like CoC and IRR. For instance, a focus on cash flow may prioritize CoC, while a strategy aiming for capital appreciation might emphasize IRR, which accounts for future cash flows and time value.
What role does market condition play in influencing these metrics?
Market conditions impact metrics by affecting property values and cash flows. In hot markets, CoC returns might decrease due to higher purchase prices, while IRR can vary based on expected appreciation and risk levels
