For new investors, the commercial real estate industry seems to have a language of its own. And, if you don’t grasp this language, reviewing potential deals can pose a major challenge. More precisely, if you don’t have an intimate understanding of these terms and concepts, analyzing commercial real estate deals is next to impossible. As such, we’ll use this article to provide an in-depth explanation of two commonly used metrics in deal analysis: IRR and the equity multiple.
Specifically, we’ll cover the following topics:
- The Importance of Comparable Metrics in Commercial Real Estate Analysis
- Pro Formas and Cash Flow Projections
- Calculating Internal Rate of Return (IRR)
- Calculating the Equity Multiple
- What’s a “Good” Commercial Real Estate Deal?
- Final Thoughts
The Importance of Comparable Metrics in Commercial Real Estate Analysis
With single-family homes, comparing investment options is a fairly straightforward process. To determine value, you look at market comps, an option due to the relative uniformity and number of these homes. To determine investment criteria, you ask: do rents cover expenses and debt service? Does it provide regular cash flow?
With commercial real estate, these questions certainly still apply. But, due to the unique nature of each commercial property, investors cannot simply look to comps to determine value. Instead, using the commercial value formula, investors measure the relationship between capitalization (cap) rate, value, and net operating income (NOI). That is, value equals NOI divided by cap rate.
NOTE: NOI equals a property’s revenues minus its operating expenses. As such, it does not include either mortgage interest expense or depreciation.
Conceptually, cap rate represents the unleveraged returns on a commercial property. In other words, if you paid cash for a property, what annual return would you receive? In theory, cap rate provides a standardized metric for comparing dissimilar commercial properties. In reality, this measurement fails to provide investors adequate information to analyze a deal’s merits.
Instead, most investors primarily use two other metrics to analyze commercial deals: 1) internal rate of return (IRR), and 2) the equity multiple. These metrics, which we’ll discuss in detail below, provide investors key insight into the returns they’ll receive on invested capital – leveraged or unleveraged. As a result, both IRR and the equity multiple serve as extremely useful tools in answering the question: how can I most effectively allocate my capital?
Pro Formas and Cash Flow Projections
Before diving into IRR and the equity multiple, we need to briefly cover two other concepts necessary to commercial real estate investment analysis: pro formas and cash flow projections.
Inherently, when you analyze a real estate deal, you look to the future. This means that you must base your analysis on estimates, that is, projections of future performance. When underwriting a commercial real estate deal, investors create projected financial statements, known as pro formas. A pro forma will combine historical analysis, assumptions about future performance, and investor experience/insight to project a property’s annual NOI for the deal’s time horizon.
For example, say you want to buy an apartment building and have a 10-year exit plan. In underwriting the deal, you would develop pro formas for that 10-year period, which would allow you to analyze the deal’s potential.
But, investors don’t typically measure a deal’s potential by its NOI. Rather, they want to analyze its cash flows. Accordingly, deal analysis usually takes a step beyond pro forma development: cash flow projections. NOI does not include mortgage interest or principal. But, both of these represent cash outlays. As such, to translate NOI into projected cash flows, investors subtract debt service, that is, mortgage principal and interest. When you do this, you are left with your annual, pre-tax cash flows for a deal.
NOTE: Investors can develop more complicated cash-flow models that account for tax effects, but for the sake of this article, we will assume pre-tax results.
Once you have a deal’s projected cash flows, you can translate them directly into IRR and equity multiple to analyze a deal’s merits.
Calculating Internal Rate of Return (IRR)
IRR relates directly to all of a property’s cash flows over the life of an investment (as opposed to cash-on-cash return, which looks only at annual performance). Conceptually, IRR projects the interest an investor will earn on each dollar invested in a commercial property. Mathematically, IRR equals the interest rate where the present value of future cash flows (projected annual cash flows plus property sale proceeds) equals the initial cash investment. Put differently, IRR represents the long-term yield a property will generate based on your initial investment, accounting for the time value of money.
Most investors have a designated hurdle rate – or required rate of return – that they must meet for a certain type of investment. With real estate, IRR provides an ideal metric for this required return. Investors can look at a property’s projected IRR and decide whether, for the associated risk, the return justifies the cash investment. For instance, if an investor has a hurdle rate of 12% for 10-year investments, a commercial deal projecting a 10-year IRR of 15% would meet that threshold, whereas a 10% IRR would not.
Assume that you have an opportunity to purchase a stabilized apartment building. You can buy it for $1,250,000 at 80% LTV, meaning you’ll have an initial cash investment of $250,000. After completing your pro formas, you determine Year 1 cash flows will be $10,000, and they will increase by 2% every year. At the beginning of Year 10, you will sell the property and, adjusting for loan amortization and exit cap rate, estimate receiving $400,000 at sale (ignoring taxes):
With IRR, the question becomes: what is the interest I’ll earn on each dollar of that initial $250,000 over the investment’s lifetime, assuming the above projected cash flows? While you can run these calculations by hand, it’s far easier to just use the Excel or Google Sheets IRR formula. Doing so, the above cash flows generate an 8.12% IRR.
Calculating the Equity Multiple
Equity Multiple Overview
IRR serves as a crucial metric in analyzing deals for two reasons. First, as a discounted cash flow model, it accounts for the time value of money. Second, it provides a single interest rate that investors can compare against a required rate of return, making it a quick and user-friendly method of comparing multiple deals.
But, IRR also fails to explain how much total cash an investor can expect to receive from a given deal. To answer this question, investors use a second metric – the equity multiple – to complement IRR. While the equity multiple does not account for the time value of money, it does tell you how much cash – relative to your initial investment – you’ll receive from a deal. More specifically, a deal’s equity multiple equals the total cash received divided by the initial cash investment.
Equity Multiple Example
Continuing the above example, we know that the deal will result in an IRR of 8.12%. To complement this metric, the equity multiple will tell investors, based on the initial $250,000 investment, how much cash they can expect to receive in a deal.
To calculate this equity multiple, you first need to sum all cash distributions (Year 1 through Year 10 in the above table) – approximately $497,550. But, this absolute number does not allow for deal comparison. That is, if you receive $1,000,000 in distributions from another deal, you don’t know whether that’s better or worse without also looking at the initial cash investment. Accordingly, we divide these distributions by the initial cash investment to get a deal-specific equity multiple of 1.99.
In other words, ignoring the time value of money, you can expect to nearly double your initial cash investment of $250,000 in this deal.
What’s a “Good” Commercial Real Estate Deal?
After explaining the above metrics, the next logical question becomes: okay, so what’s a “good” deal? Unfortunately, no universally “good” deal exists. Instead, investors need to first determine their desired A) investment time horizon, and B) risk tolerance. From these items, you can determine your required rate of return.
For instance, you may look at a 10-year deal and determine your required rate of return based on the risk-free rate plus a risk premium. That is, say 10-year Treasurys (a standard measure of risk-free returns) are currently at 2%, and, for the perceived risk of a given real estate deal, you require an 8% risk premium. In this scenario, you’d have a required rate of return (i.e. minimum IRR) of 10% (2% risk-free rate plus 8% risk premium). In other words, if your projected IRR came in less than 10% on this given deal, it wouldn’t meet your investment criteria, whereas an IRR of 10% or greater would.
But, as discussed, IRR should also be viewed in conjunction with a deal’s equity multiple to analyze total cash distributions. For instance, assume you have two potential commercial real estate deals, both of which have 5-year time horizons – Deal X and Deal Y:
|Deal X||Deal Y|
Assuming a 5.5% minimum IRR, both Deal X and Deal Y meet your requirements. And, if you used IRR alone, you would opt for Deal Y, as it has a higher IRR. However, when you include the equity multiple as an additional deal metric, you see that Deal X returns more cash than Deal Y. Accordingly, in deciding on Deal X or Deal Y, you would need to further refine your priorities regarding total returns and the timing of cash flows.
This is why these two items must be viewed as complementary metrics in analyzing potential commercial real estate deals. Both offer different insight into a deal’s merits, so investors should view them together.
The language of commercial real estate can certainly be intimidating – to new and experienced investors alike. But, with a solid grasp of both IRR and the equity multiple, investors arm themselves with two key tools for analyzing potential deals.
If you’d like to discuss different real estate investing options for your unique situation, we’d love to chat! Drop us a note, and we’ll set up a meeting to talk about available investment opportunities – and how to effectively analyze those potential deals.