All Investments Are Not Created Equal – Important Metrics
You’ll find very quickly that there are about as many types of metrics to measure the returns of an investment as there are investment opportunities available to you. It’s important to know what the metrics are telling you, and which ones measure the results you are looking for your specific situation. We’ll outline the three main metrics you should pay attention to when investing in your first or subsequent passive investing opportunities below.
Cash on Cash Return (COC)
The cash-on-cash metric is really important for the cash flow investor that is trying to replace their W-2 income in order to leave their job or for those that have already retired and need to have consistent and steady income. The COC calculation measures the annual returns for a given period which is usually one year. To understand this calculation, assume you have a $100,000 investment, and it produces $4,000 in cash flow in the first year of the investment. You're COC returns would be 4% ($4,000/$100,000).
Average Rate of Return (ARR)
The ARR is the average annual returns that is generated over the duration of the investment. It is calculated by adding up COC returns of each year and then dividing by the total number of years. Let's assume the same $100,000 investment above produces $4,000 year one, $6,000 year two, $8,000 year three and $10,000 year four. The total returns are $28,000 over four years so your average returns are 7% ($28,000/4/$100,000).
Internal Rate of Return (IRR)
The internal rate of return metric is likely the single most important metric to look at when considering the overall performance of an investment and is probably the most important metric for the growth investor that is simply trying to grow their nest egg as fast as possible. The IRR metric helps to measure not only how much returns you get from an investment but also how fast you get the returns. As they say, a dollar earned today is more important than a dollar earned tomorrow.
The calculation on this metric is a little too complicated for the purposes of this article, but the basic premise is that the sooner you get your invested dollars back, the more valuable they are to you as the investor. To show a very high-level example, the IRR on a $100,000 investment that returns $10,000 per year for 5 years is higher than an investment that returns nothing for the first 4 years and then provides a $50,000 return in year 5. By getting the $10,000 back each year, an investor can reinvest those dollars to help the total returns on those dollars increase faster over time.
Be careful that you are using the same metrics when you are comparing investments across different operators or asset classes. And more importantly, be sure you are using the right metrics for your specific investment needs. The cash flow investor will want to pay more attention to the cash-on-cash returns and the growth investor will likely want to pay more attention to the internal rate of return.
@Randy Smith I'm new to the forums here but all your posts are $$$$ You can't be comparing apples to oranges especially when you're pitching deals to investors. 100% agree that IRR is the most important metric to look at and it's the only metric we use when evaluating deals. I'm curious as a passive investor on a value add muti-family deal what IRR benchmark are you looking to hit?
Quote from @Connor Lawson:
@Randy Smith I'm new to the forums here but all your posts are $$$$ You can't be comparing apples to oranges especially when you're pitching deals to investors. 100% agree that IRR is the most important metric to look at and it's the only metric we use when evaluating deals. I'm curious as a passive investor on a value add muti-family deal what IRR benchmark are you looking to hit?
@Connor Lawson Most deals are going to show IRR around 15-18% these days in the value add multi family space, but it's more important to look at what the group/operator is using for their assumptions and what they have done in the past. Groups can make the IRR look like anything if they adjust their assumptions.
Love your posts @Randy Smith! They're super informative and helpful. I'm curious to your thoughts on the importance of the Equity Multiple metric? I feel like passive investors would want to know what multiple they'd earn on their cash during the hold period. But at the same time the metric is limited because it doesn't help to compare returns from real estate to those of other asset classes like an IRR does.
I think the EM also does a good job of showing what the return on capital is after the return of capital. Like if you invest $100K and I distribute 10 payments of $10K back to you, nothing really happened (technically you lost money actually). But if I tell you that the investment earned a 1.3x EM, then you'd know that I distributed all your cash back plus 30% on your money.
Is this the right way of thinking about it?
@Snehann Kapnadak. Thanks for the nice words and also bringing up this metric as it is another one that is used regularly in the space. I didn't include it in the post as the other three are better measurements for each type of investor (Growth or Cash Flow). Equity Multiple has some drawbacks as time frame is not factored in. If I told you that I got a 1.8x EM on a deal, you would not know if this was a good deal or not. Now, if it was a 1.8x EM over 20 years, you would know this was a bad investment, but if it was in 14 months (like my first full cycle investment in this space), you would know it was an amazing deal.
I like to see them all so I can put the big picture in focus for my needs. Any one measure on it's own can be incomplete and sometimes used to be misleading to those that are new or less numbers inclined.
@John Sayers. This is a really great note. Any one of the metrics can tell you part of the story, but you really need to see them all to get a full picture of what exactly is happening with your investment dollars. Each person has their own unique needs from an investment, and these metrics (as well as Equity Multiple) can help you identify the best investment for your specific needs.
@Randy Smith thanks, that makes a lot of sense.