Video: Real Estate Right Now | Valuation Metrics (Part 2)
January 18, 2022 | BY ALAN BOTWINICK & BEN SPIELMAN
Roth&Co’s latest video series: Real Estate Right Now.
Presented by Alan Botwinick and Ben Spielman, co-chairs of the Roth&Co Real Estate Department, this series covers the latest real estate trends and opportunities and how you can make the most of them. This episode discusses more critical valuation metrics used to calculate the potential of an investment property.
Watch our short video:
In our last video we talked about three useful tools to help calculate the potential of an investment property: GRM (Gross Rent Multiplier), PPU (Price Per Unit) and Cap Rate (Capitalization Rate). Moving forward, here are additional metrics that can help an investor dig even deeper.
The Internal Rate of Return (IRR) is a metric used in financial analysis to estimate the profitability of a potential investment. It represents the annual rate of return on your investment, over the life of that investment. The higher the IRR, the healthier the return.
The IRR is calculated by computing the net present value of the investment. The Net Present Value (NPV) is the amount that the investment is worth in today’s money. To successfully analyze the data, future values must be considered against today’s values. Why? Because today’s money is more valuable than the value of the same money later on. This is also known as the time value of money.
When we calculate the IRR, we solve for “a rate”, so that the Net Present Value of the cash outflows and inflows is zero. That “rate” is the IRR. We achieve this by plugging in different interest rates into our IRR formula until we figure out which interest rate delivers an NPV closest to zero. Computing the Internal Rate of Return may require estimating the NPV for several different interest rates. The formulas are complex, but Microsoft Excel offers powerful functions for computing internal return of return, as do many financial calculators.
Simplified, here is how it works:
If you invest $10,000 in year one and receive an $800 return annually through Year 5, then exit the investment for $15,000, you would calculate the IRR as follows:
This scenario yields an IRR of 18%.
Here’s a similar scenario that yields a different result:
This scenario yields an IRR of 15%
Which scenario provides a better return? Looking at the bottom line is deceptive. By calculating the IRR for both investments, you would see that the IRR on the second investment, 15%, is a nice return. However, the first investment, with an 18% IRR, would be a better use of your money.
The Cash-on-Cash Return tells the investor how much cash the investment will yield relative to the cash invested. It measures the annual return the investor made on a property after satisfying all debt service and operating costs. This is a helpful analytic for many real estate investors who commonly leverage investments by taking out mortgages to reduce their cash outlay. The metric is the most helpful when liquidity during the investment period is important to the investor. One of the most important reasons to invest in rental properties is cash flow, and Cash-on-Cash return measures just that. Put simply, Cash-on-Cash return measures the annual return the investor made on the property after satisfying all debt service and operating costs.
Here is a simple CoC Return example:
Let’s say you buy a multifamily property for $200,000, putting down a $40,000 deposit, and assuming a $160,000 mortgage. Your gross rents are $30,000 monthly, with $20,000 of operating expenses. Additionally, you have $9,000 monthly debt service payment comprised of $7,000 interest and $2,000 principal. Because principal payments are not an expense, Net income is $3,000 annually.
However, when calculating Cash-on-Cash, you consider the debt service as well, bringing your return to $1,000 monthly, or $12,000 annually.
Comparing your investment’s yearly net income of $12,000 to the $40,000 down payment, you have a Cash-on-Cash annual return of 30%. While there is no specific rule of thumb for what constitutes a good return rate, the general consensus amongst investors is that a projected Cash-on-Cash return between 8% to 12% implies a worthwhile investment.
Financial metrics are important and useful tools that can help an investor make smart, informed decisions. Whereas any one metric may have limitations, by considering a combination of metrics commonly used for comparing, in addition to tracking performance or value, an investor can target a strategy and analyze risk in a potential investment opportunity.
This material has been prepared for informational purposes only, and is not intended to provide, nor should it be relied upon for legal or tax advice. If you have any specific legal or tax questions regarding this content or related issues, please consult with your professional legal or tax advisor.