Whether you are looking to purchase your own multifamily property or invest passively in someone else’s deal, internal rate of return (IRR) and cash on cash (CoC) are two of the most important metrics to understand and implement. While any one return metric never tells you everything you need to know, these two calculations are crucial when determining whether a potential deal will hit your investment criteria.
The simpler of the two is the cash on cash return. This is defined as:
Cash on Cash = Annual Dollar Income / Total Dollar Investment
It is important to note that the cash on cash return typically only includes the monthly cash flows from operations and typical does not include profits from a capital event. That is, things like sale or refinance proceeds aren’t included unless otherwise noted. Here is an example of three years of a property’s cash flows:
|Year 0||Year 1||Year 2||Year 3|
|($100,000) Investment||$6,000 Cash Flow||$8,000 Cash Flow||$12,000 Cash Flow|
Some quick math will reveal that our cash on cash returns were 6%, 8%, and 12% respectively and the average annual cash on cash return for the three years is 8.7% calculated as ((6,000 + 8,000 + 12,000) / 100,000) / 3 years. This is a great way to see how much cash this asset will spit off each month (and often paid out to investors quarterly). However, you can factor in sales proceeds to see the total cash on cash return which would look like this:
|Year 0||Year 1||Year 2||Year 3|
|($100,000) Investment||$6,000 Cash Flow||$8,000 Cash Flow||
$12,000 Cash Flow +
$50,000 Sale Proceeds
If you factor in the proceeds from a sale, our cash on cash calculation looks like this: ((6,000 + 8,000 + 12,000 + 50,000) / 12) / 3 years = 25.3%. Obviously this is much higher than the 8.7% calculated when only using the monthly cash flows and not the sales proceeds. This number can often be very significant in apartment deals where the sponsor is fixing up the property in an attempt to increase value. It is very common to see the total cash on cash return for a property be double or even triple digits. On the other hand, without sales proceeds factored in, cash on cash returns generally range from 0% – 20% depending on the goals of the investment. A good rule of thumb is to look for an average annual cash on cash return that is at least equal to any preferred return that an apartment sponsor may offer.
Internal rate of return is often a bit more confusing to a less sophisticated investor. The formal definition of IRR is a discount rate that makes the net present value (NPV) of all cash flows from a particular project equal to zero. Net present value is complex calculation…take a look at the formula below and then be thankful that we do not have to calculate this by hand!
To put it more simply, IRR is a calculation that factors time into the equation. Imagine you were presented two opportunities for your $10,000 investment. Investment one pays you $1,000 at the end of each year for five years. Investment two pays nothing each year but then pays $5,000 at the end of the 5th year. Which one is better? Keep in mind the cash on cash return is the same for both (5,000 / 10,000) / 5 years = 10%.
Yea can calculate the IRR for each of these opportunities very easily using excel. Check that out here. Let’s see what the excel IRR calculation comes up with for the above investment opportunity:
|Year 0||Year 1||Year 2||Year 3||Year 4||Year 5||IRR|
We can see that the IRR is higher for the first scenario and logically, that makes sense. If you don’t receive any money back until the end of the investment you forfeit the opportunity of reinvesting the returns from the early years in other things. When the return on two investments are the same, the one where you receive your money back faster will have the higher IRR. That is why we say that IRR calculates a return but also factors in how quickly you receive your money back. IRR for a real estate project can vary widely just like total cash on cash return although most investors are targeting at least a double digit internal rate of return.
Cash on cash and internal rate of return should be used in tandem when analyzing a potential real estate acquisition. If you can understand both of these metrics and what they measure, you will be in a great position to make better investment decisions. Once you review enough deals, you will start to figure out what you required rates of return are so you can more quickly pursue opportunities that come your way!