Understanding the real returns of your real estate properties is a critical part of assessing your investments. Today, Lon Welsh is sitting down with us to talk about four common ways we can look at returns for passive investments, three ways to look at passive investment returns, and the most overlooked metric everyone needs to understand.
- Listen to the podcast “#399: 4 Metrics of Measuring Real Estate Returns: Which One Is the Best?” Denver Real Estate Investing Podcast
- Watch the YouTube video (at the bottom).
- Read the blog post. Note, the blog is an executive summary. Get the in-depth breakdown from the podcast or video.
4 Metrics for Evaluating Active Investments
Lon finds that there’s a lot of confusion about how to measure success in returns, especially among newer investors. There are pros and cons to each metric we’re going to talk about, and there’s no one right answer for how to make this calculation. To illustrate these metrics, we’re going to use a rental property as an example. All of these metrics apply equally to different asset classes: condos, houses, small apartment buildings, and even office buildings.
Metric 1: Cash on Cash Return
This is a metric people usually gravitate to first. If you put down $100K and have $10K left over, that’s a 10% cash on cash return. This is a simplistic way of looking at returns and is akin to an iceberg: you can only see a small portion that’s above the water, but there’s much more underneath.
Metric 2: Cap Rate
The capitalization rate, or cap rate, is a moment in time—today’s snapshot of how the property is performing. Cap rates are most commonly discussed with commercial properties, but they are useful for assessing smaller residential rental properties, too.
To calculate the cap rate, subtract vacancy from the collected rent, subtract operating expenses, and that leaves with the Net Operating Income (NOI). Take the NOI and divide it by the purchase price to get your cap rate. If you can find a 6% cap rate in this market, that’s pretty good.
As the market changes and interest rates go up, we’ll see cap rates also increase a bit, which will have an impact on prices. This is a more complex subject that we’ll go into in another episode.
Metric 3: Gross Rent Multiplier
The Gross Rent Multiplier, or GRM, is a little old fashioned now. To find out the GRM, you need the purchase price of the property and the monthly rent. If you purchase a property for $100K and the monthly rent is $1K, the GRM of that property is 100K divided by 1K, which comes to 100. Seen any like that lately? I haven’t.
Many investors will say they want a 100 GRM, but that’s a unicorn in today’s market.
GRM is good as a first cut analysis. If you’re lucky to have a lot of inventory to choose from, calculating GRM is a quick way to narrow down your pool. If a property doesn’t have an attractive GRM, none of the other metrics will work, either.
Metric 4: Internal Rate of Return
Internal Rate of Return (IRR) is the most complicated metric to calculate. You can’t use a calculator, but it’s fairly easy to figure out using an Excel spreadsheet. The IRR tells you the average rate of return each year over the lifetime of the investment. You can also calculate the IRR pre or post tax. This is the measure most commercial real estate professionals use.
3 Metrics for Assessing Passive Investments
Some of the returns on passive investments are calculated differently than for active investments. Lon has been working with active investments for about 20 years now, and finds that he’s less excited about doing the work and fighting the wars needed for active investing. With passive investing, someone else is doing the heavy lifting, which makes it an attractive option.
Metric 1: Cash on Cash
This is calculated the same way as for active investments. It’s how much money you’re putting in compared to how much you’re getting from the investment.
Metric 2: Internal Rate of Return
The IRR is the gold standard metric for calculating passive investing returns. It’s so important because it captures the idea of compounding interest. Lon’s favorite description of compounding interest is this quote attributed to Albert Einstein: “Compound interest is the eighth wonder of the world. He who understands it, earns it; he who doesn’t, pays it.”
The return on your investment in year one gets reinvested, which means that you get your initial investment plus the amount reinvested. Then the next year, you do it again and you have two piles of cash in addition to the original. Over 20 years, what that amount can do is amazing.
For example, say you invest $100K into a fund for an apartment complex in Houston. In year two, there’s no cash flow because there’s construction work to improve the building. In year three, the building is leased and gets a refinance, which gives you most, if not all, of the initial investment back. Since you still own the asset in year four, you get 12% cash on cash return of your initial investment. In year five, you get cash flow plus the equity if you sell.
IRR is the only method that takes into account cash in and cash out, and calculates the rate of return in one neat, easy package. It also allows you to compare multiple investment opportunities in a one to one manner.
Method 3: Multiple on Invested Capital
The Multiple on Invested Capital (MOIC) answers the question, “How much did I end up making relative to my initial investment?” If you put $100K down and over the course of 5 years get $150K back, the multiple on invested capital is 150K divided by 100K, or 1.5.
This is a useful way of thinking about returns when you have a specific goal in mind, paying for a child’s college. You can figure out how much to invest now and how much you’ll get on the backend.
A drawback of MOIC is that it’s not sensitive to time. The calculation is the same regardless of your return coming in two years or five years. However, getting that kind of return in two years is a lot more exciting than getting it over five years. IRR can calculate this measurement where MOIC cannot.
What’s the Number One Metric Investors Overlook?
Time. This is a metric that doesn’t appear on spreadsheets, and it took me a couple of years to appreciate the time I’m putting into my investments.
Lon says that in 20 years of teaching investing classes, he’s seen a lot of investors who think their time has no value. That’s why they want to self-manage their properties.
Most people investing in real estate are not unemployed; rather, they’re busy professionals. If an investor works a job where they make $200K a year, that means they make $100 an hour (50 weeks / a year after vacation * 40 hours / week = 2,000 work hours a year). It’s an important exercise to figure out your hourly rate as well as the hourly rate you want to have.
If you self-manage a property, compare the time spent on it to your billing rate. Is the work you’re doing self-managing a good use of your time at the rate you make? Unless you’re passionate about property management, it’s probably not the best use of your time.
This also applies to investors trying to find the absolute best investment in the market. They’ll turn over every rock no matter how long it takes. Normally, it takes 40 hours to find a property, but these investors will spend 140 hours. If your billing rate is $100 an hour, that’s $10K that you’ve added to the cost of your project. Is finding a property that likely has only incrementally stronger returns worth $10K of your sweat?
Connect with Us
If you want to see how you can use these metrics to optimize or grow your portfolio, reach out to us for a free investment consultation.