When you are reviewing a commercial real estate deal, you will invariably come across these 3 common performance metrics that is meant to illustrate how well a deal is meant to perform. But do you really know what they mean, how they are different from each other & how they are meant to be used to compare one investment from another.
All of these metrics are used to represent the return on an investment and can be used both as a forward looking estimate of performance and/or a backward looking evaluation of a completed investment
To better explain these metrics, lets use a hypothetical investment of $100,000 in year 0, with a yearly distribution of $8000 for 5 years, with an eventual sale and return of original investment & profits of $160,000 in year 5
Average Annual Return
The Average Annual Return is simply the total return from an investment, including all the cash distributions & the profits from the sale divided by the number of years of the investment. In the above example, you would have a total return of $100,000, which includes the $40,000 of distributions over 5 years plus the $60,000 of profit split upon sale in year 5
Avg. Annual Return = (8000+8000+8000+8000+8000) + 60,000 = 20%
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Though this tells you your average return over time, it does not take into account the timing of your returns & treats all returns over time the same.
To correct that problem, enter the Internal Rate of Return or IRR
Internal Rate of Return (IRR)
The IRR is one of the key performance metric that a lot of investors look at when evaluating an investment, since it takes into account the time value of money using the Discounted Cash Flow(DCF) method, which is a separate topic for discussion in itself, where it measures the percentage rate earned on each dollar invested for each period its invested for. It is basically the discount rate that will be applied to a series of cash flows that will bring its net present value to 0.
Investors while evaluating different investments, are not only looking at the returns they would potentially receive but also when they would potentially receive these returns over time. The IRR is one of the metrics that is used, since it helps normalize returns over different periods to its Net Present Value(NPV) i.e., the time value of your money, where a dollar earned today is worth more than a dollar earned in the future due to effects of inflation, opportunity cost, etc.
There are a number of online calculators and excel provides an easy formula to calculate the IRR based on an initial investment amount and a series of time based cash flows.
One of the key concerns that some folks have raised, which may not necessarily be true, is that the IRR ignores the reinvestment rate of those cash flows, since it assumes those periodic cash flows are reinvested at the same rate as the IRR, which may be unrealistic, especially if the IRR is high. There are other metrics like the Modified IRR(MIRR) which helps correct that problem but is beyond the scope of this discussion.
Equity Multiple (EM)
Equity multiple measures how much total cash you'll get back from an investment over the life of the investment & is basically the total cash distributions from an investment over the life of the project divided by the total equity invested
In the above example, the total cash distributions received from the investment was $200,000, including the original investment of $100,000, divided by the original investment of $100,000 which equals 2.0x
So, what does the equity multiple tell you? An equity multiple of less than 1.0x means you are getting back less than what you invested. An equity multiple of greater than 1.0x means you are getting more than you invested. In our example, an equity multiple of 2.0x means for every $1 that you invest, you are getting back $2 (including your original $1) basically doubling your money.
The fact that you are getting more than 1.0x means you are getting more than you invested but it doesn't tell you anything about the timing over which that return is generated. In other words, an equity multiple of 2.0x over 5 years means you are doubling your money in 5 years and is way better than the same equity multiple of 2.0x over 10 years
While the above performance metrics help one evaluate real estate investments there are numerous other factors that should be taken into account while evaluating a real estate investment