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These terms are tossed around by syndicators and passive investors alike. Below are a few must know terms if you ever plan on investing in a real estate syndication or to start one of your own.
Internal Rate of Return (IRR)
The IRR is the most indicative metric used in commercial real estate investing. It is an annualized percentage and reflects all profit gained from the asset each year. We typically like to see an IRR between 15% and 20%. Lower than 15% might not be worth your investment dollars or the syndicator’s time, while more than 20% certainly happens often, if the syndication team is advertising these numbers, we would heavily scrutinize their underwriting and really draw down on the assumptions they have made. The IRR differs from ARR because IRR considers the time value of money by factoring in the timing of cash flow and capital events.
Annual Rate of Return (ARR)
Annual rate of return is the same as IRR except it does not factor in time value of money; and therefore, can be slightly skewed by inflation. This number will be higher than the IRR value.
Cash-on-Cash Return
Cash-on-Cash measures the cash income (cash flow) against the initial amount invested. This is a very popular metric especially among first time investors. Of note, this metric disregards the mortgage amount and only considers the cash invested. It also does not include the return form capital events such as refinance or sale. We like to this at 8% or higher. Basically, this metric tells the investor how soon they can recover their initial cash investment from cash flow.
Cash Flow
Cashflow is simply the profit left over after annual debt service, operating expenses, capital expenditures, etc.
Equity Multiple
This is a simple metric that measures the profitability of the investment. It reflects the IRR at the end of the hold period. For example, a 2x equity multiple means you double your money over the course of the hold period. An IRR of 20% with a 5 year hold period would reflect a 2x equity multiple.
Preferred Return
Preferred return is the percentage that is distributed to investors until a certain rate of return is reached. During the hold period most, if not all, of the return is coming from cash flow. We usually like to see a 7% to 8% preferred return for investors. This means investors receive 100% of the cash flow until a certain rate of return on the initial investment is achieved. In other words, investors would receive 100% of cash flow in a given year until the cash flow for the year equals 8% of the investors initial cash investment. After the preferred return is achieved, cash flow distributions shift to a split between investors and the syndication team. Usually, 70/30 or 60/40. If the property is underperforming and does not reach satisfy the 8% preferred return, then the remaining rate of return is tacked onto the following year and continues to accrue from there.
Loan-to-Value
This value is simply the mortgage amount divided by the property value. At the time of this article October 21, 2024, a 70% is pretty good, and even 60% is starting become acceptable. We like this value because it shows two things that are important to an investor.
- 1) the banks confidence in the partners on the deal. If they are inexperienced or don’t have someone experienced on the team, smaller banks simply do not have as much confidence in the business plan and, therefore; will not loan more than a certain percentage of the purchase price.
- 2) A less favorable loan-to-value increases the odds of a capital call and underperforming asset. The bottom line is investors are expensive and mortgages are cheaper money. In other words, the amount of return given to investors over the course of the hold period far exceeds interest paid to the lender. This is even true during some of the higher interest periods over the past couple of years. Lower loan-to-value means the syndicators need to raise more money from investors, thus decreasing IRR. ALWAYS pay attention to lending terms associated with an asset. This can make or break a deal.
