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For real estate investors, syndicators and others involved in the field, investment terminology can appear to be an alphabet soup of mysterious acronyms. There are three in particular that are related to the return on real estate investments, and each has its own unique meaning and purpose. They include Cash Yield (a.k.a. Cash-on-Cash Return), IRR, which is an abbreviation for Internal Rate of Return, and Equity Multiple. RealVantage will discuss the differences of each and how they apply when exploring real estate investments.
Internal Rate Return
One of the most common metrics used to gauge investment performance is the Internal Rate of Return (IRR). It is one of the first performance indicators you are likely to encounter when browsing real estate opportunities. The IRR is defined as the discount rate at which the net present value of a set of cash flows (ie, the initial investment, expressed negatively, and the returns, expressed positively) equals zero.
In more simple terms, it is the rate at which a real estate investment grows but it also factors in the time sensitive compounded annual rate of return. One of the keys to IRR analysis, though, is realising that timing plays an important role. The time or duration of the investment hold period and the timing that cash distributions are paid to investors both have a big influence on this equation.
Typically expressed in a percent range (i.e. 12%-15%), the IRR is the annualised rate of earnings on an investment. While there is no concrete definition tying asset class to IRR, the following IRR ranges can be generalised as follows.
Read also: What is Compound Annual Growth Rate (CAGR)?
Cash Yield is the simplest way to evaluate the performance of a real estate investment. It utilises a formula to calculate the return on investment by taking the property’s annual net cash flow and divide by the investment’s down payment, and is expressed as a percentage. One important detail to keep in mind is that Cash Yield doesn’t include the property’s appreciation or any principal debt payments.
Appreciation is only taken into consideration when it is realised after the property is sold. It also doesn’t include principal debt payments. Suppose you bought a property and your net cash flow was $5,000, and the cash invested in your property was $50,000. Using that example, your Cash Yield is 10% ($5,000/$50,000). The net property investment is usually the down payment — which is the property’s cost minus the amount you borrowed.
The equity multiple is defined as the total cash distributions received from an investment, divided by the total equity invested. Here is the equity multiple formula:
For example, if the total equity invested into a project was $1,000,000 and all cash distributions received from the project totaled $2,500,000, then the equity multiple would be $2,500,000 / $1,000,000, or 2.50x.
What does the equity multiple mean? An equity multiple less than 1.0x means you are getting back less cash than you invested. An equity multiple greater than 1.0x means you are getting back more cash than you invested. In our example above, an equity multiple of 2.50x simply means that for every $1 invested into the project, an investor is expected to get back $2.50 (including the initial $1 investment).
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