Commercial Real Estate is an industry full of jargon – much like other industries, I’m sure. CRE is also a little like the wild west. There is really no standard on how to evaluate one investment versus another. As investors are unique in their motivations and goals, there are many different metrics to consider when evaluating income-producing properties.
My preferred method is the Internal Rate of Return (IRR). IRR tells you what return you are making on your investment while your money is in the deal. It is generally an annual number. So, if I look at a deal, and the IRR is projected to be 14.5%, then I will expect my investment to make, on average, 14.5% while it is in the deal. To calculate IRR, you need to know the amount of your initial investment, how long you project your money to be in a deal, what your annual cashflows could be, and what you expect to make on the sale of the property when you exit.
I’ve created a quick video that shows you how to easily do this in Excel.
And before my mom emails me, I see that I had misspelled annual in the video…twice. I’m clearly better at numbers than I am at spelling.
Cash on Cash is another metric some investors use to evaluate an investment. This metric tells you what return you receive on an investment over the course of one single year. In the video above, the IRR in the scenario is 13.8%, while the Year 1 Cash on Cash is 10%. That tells you that over the course of the deal, your money will make you 13.8% annually (factoring in the sale at the end). However, in year 1, you will receive a 10% return. You have a Cash on Cash of 10% for that particular year.
Many investors like the overall view of their projected return and will favor IRR. While IRR gives you that overall view, it is more difficult to calculate as you need more information and rarely can you do it in your head.
Some investors prefer to understand what return they will get each year. These investors will often lean toward Cash on Cash. Plus, it is easy to calculate. If you have $1,000,000 in the deal, like the scenario in the video, and you project you will receive $100,000 back in the first year, then the Cash on Cash is 10% – $100,000/$1,000,000. It is much easier to calculate and gives a more granular view of how the investment might perform in a given year.
When I put together a group investment deal, these two metrics are essential to understanding. An investor in one of our deals might be able to expect an IRR of 18+%, but the year 1 Cash on Cash might just be 6%. As we improve the property, the Cash on Cash for subsequent years might improve. The IRR tells you what your money is doing for you over the course of the entire deal, while the Cash on Cash tells you what money you might get back in a particular year.
Understanding the key metrics when investing in Commercial Real Estate is essential. Understanding the differences, as well as knowing your own goals and preferences, is even more important. If you would like to speak with us about your own goals or have questions about how to evaluate CRE investments, click the button below. We’d love to speak with you.