ROI versus cash on cash
Salt Lake City, UT · Member since 2013 · 43 posts · 2 votes
I am looking at various investment opportunities including syndicates, limited partnerships and other sorts of deals to join. It would be ideal to be able to compare apples to apples, but it doesn't seem to be working out that way. Some deals discuss an IRR estimate, others speak about preferred cash returns and then capital appreciation. If I was a math guru, I could probably plug capital appreciation estimates and CoC estimates into a formula and figure out IRR, but my calculus skills aren't that good. Does anyone have a suggestion regarding how to figure this out? I looked through my book by Frank Gallielli but couldn't figure out the answer to this.
Thanks,
Jeffrey Kovnick
Cash on cash return is what I use...
Monthly Cashflow x 12 / Dowpayment(or total cash in the deal) = Cash on Cash return.
I like to see any where from 15% to 25%. I have a few that are inifinite because I did a cash out refinance and have no money in the deal.
Cash on cash return is what I use...
Monthly Cashflow x 12 / Dowpayment(or total cash in the deal) = Cash on Cash return.
I like to see any where from 15% to 25%. I have a few that are inifinite because I did a cash out refinance and have no money in the deal.
Difference basically is that COC is the return on your money put in the project, or ROI includes the spread of interest or earnings with the financed amounts and is compared with your use of cash with other investments. Two different animals.
Financial ratio analysis is rather irrelevant in RE as the economics are not the same as with securities or traded liquid investments. Most look at COC as a determining factor. I use an IRR and yield compared to lending alternatives but just as a quick assessment as to use of cash. You'll never assess a property and have your estimate equal the actual return after one year or thereafter. If anyone claims they can they are either miscalculating or in error somewhere. Large corporate holdings can make sense of ratio analysis due to the size of pools held, mom and pop do it for fun to wear out batteries in their calculator.
Ratios then become relevant as historic measurements not so much as a projection for a buy decision. :)
Not what I was saying, you can only figure it after the first accounting period or year, before you buy it's guessing.
Any property that advertises IRR or any other return is eye wash to market it, your return won't be what theirs is nor can they tell you what your return will be.
Assessing alternative properties you need to use your estimates on cash injected, financing, management and income for each using your data, not theirs, that makes it apples to apples. :)
@Jeffrey Kovnick Jeff-- Sorry if my book didn't provide a path to solve your problem, but allow me to add a couple of thoughts to the discourse here:
A couple of articles I've written recently might shed a bit of light on your question, in particular a 2-part series, "The Cash-on-Cash Conundrum."
http://www.realdata.com/blog/the-cash-on-cash-conundrum-part-1/ and
http://www.realdata.com/blog/the-cash-on-cash-conundrum-part-2/
As you'll pick up from those articles, I strongly favor comparing investment opportunities by doing a DCF analysis (i.e., IRR or MIRR) rather than a simple CoC. Taking the DCF one step further, I urge doing "best-case, worst-case, in-between" projections to give you a sense of a realistic range of possibilities.
Sorry also that you had to search for an IRR calculator. As you probably know, my company's commercial software can do very robust DCF/IRR/MIRR pro formas, but I also provided a free set of Excel-based calculators and worksheets for readers of my "...Cash Flow..." book. I'll let the proverbial cat out of the bag here for all of my good friends on BP. You can download it at
http://www.realdata.com/book/download.html
It's the top item on that page. It will give you very simple IRR, MIRR, APOD, annuity functions, etc.
Regards,
Frank
... and just a quick postscript in case I wasn't clear: You should be doing your own IRR/MIRR based on your own reconstruction of the data. I would not recommend putting any credence into the metrics provided by an interested third-party, such as the seller or broker.
@Account Closed that was my challenge a few years ago when there were so many deals to choose from. How could I compare properties and which one(s) would be the strongest performers?
I invest in SF properties, and am not sure what type of deals you're looking at, but sound financial analysis applies in all cases. I make sure the deal has the ability to generate positive net cash flow, then look at IRR. I also look at net present value (NPV) of cash flows to compare deals.
As Warren Buffet just wrote in his annual letter, "Focus on the future productivity of the asset you are considering. If you don’t feel comfortable making a rough estimate of the asset’s future earnings, just forget it and move on. No one has the ability to evaluate every investment possibility."
He wasn't only referring to real estate, but he uses two real estate investment examples. cnn money has a great excerpt of the letter.
http://finance.fortune.cnn.com/2014/02/24/warren-buffett-berkshire-letter/
If I'm pitched deals that don't use IRR, I assume I'm dealing with non-finance people. The deals may still be ok, but I always run my own numbers regardless.
Feel free to message, I do have a suggestion.
The IRR is really just the cumulative cash on cash (CoC) return for the entire hold period, including the residual sales price. Whereas the CoC return that is quoted in an investment offering is typically an average of each year’s cash on cash return over the assumed hold period. An IRR will usually be higher than the CoC unless the residual sales price is lower than the purchase price (perhaps a large tenant’s lease expires or the market is in decline and the model assumes negative rental growth over the hold period).
If a sponsor simply tells you he / she is going to double your investment (red flag) and you want to approximate the total IRR, but think math is a four letter word, you can just use the rule of 72 to "back of the envelope" the projected IRR. Simply divide 72 by the hold period. If it takes 5 years to double the investment, that's around a 14% compounded return.
If you are interested in digging in to the details, I commend you as that is the only way to really understand what is driving return projections. The goal is to first reproduce the sponsor's IRR and CoC projections and then conduct a sensitivity analysis on their major assumptions. For a multifamily deal, the two critical variables are typically rent inflation (growth) and exit cap rate (sales price at the end of the hold period). It’s important to know if the success of the investment is completely driven by final sales price (very difficult, if not impossible, to predict over a long hold period) or if the investment return is comprised of a healthy balance of cash flow (somewhat easier to predict) and sale proceeds. Running your own numbers and testing assumptions will help you determine this and will give you a better feel for risk of a particular real estate investment.
Couple other considerations:
As discussed, since the quoted cash on cash projection will likely be an average of the projected cash returns over the hold period, you'll want to ask the sponsor what are his / her projected CoC returns for the first few years of the investment. Reason being, an investment might not kick off much distributable cash flow until the latter part of the hold period. If the CoC returns are zero in the first three years and then 40% in the last year of a 4-year investment, the average CoC will be advertised as 10%. Of course, this is a substantially different investment then one that distributed 10% each an every year of the investment.
Last point, you might want also want to ask the sponsor what is his / her unleveraged IRR projection. With interest rates still near historically lows, positive leverage (especially at high loan to value ratios) can "juice" the IRR and CoC returns to impressive levels, but might also hide underlying flaws with the investment. Perhaps there isn't much cash flow after debt service. The IRR might still look impressive if the investment is highly levered, but there might be little – if any – margin for error for an unexpected major capital item. This is why we use unleveraged IRR return hurdles when analyzing prospective investments. We do not pursue deals that only work (i.e. meet our return objectives) because of leverage.
Good luck!
Brad Johnson
Brad - Some very good points here, but please permit me to tweak your first statement, "The IRR is really just the cumulative cash on cash (CoC) return for the entire hold period... ."
IRR is sensitive to the interplay of the timing and the magnitude of cash flows. An example I use in my grad-school class is to show two properties, each with a 10-year hold, each requiring the same initial cash investment, and each having exactly the same cumulative cash flow (including proceeds of sale). With one of the properties I vary the size and timing of the cash flows -- keeping the total always the same -- and demonstrate that the IRR can differ dramatically from that of the first property even though the initial investment and the total cash returned is the same.
I think CoC is a bit misleading on leveraged investments because it neglects the core value of a mortgage, which is increasing equity on loan pay down. You can manipulate CoC by extending out the mortgage terms. But your equity build is slower. My method is to simply see if the SFR can pay itself off in 10 years or less with zero cash flow and 25% down payment. IF it can, its a good deal in my book. It means my equity will increase 4X in 10 years assuming zero appreciation. It also fits conveniently with my investment horizon of wanting to have passive income enough to pay all my expenses in 10 years.
Absolutely Frank, we're in agreement. I probably confused things with my attempt to simplify the definition for those unfamiliar with investment modeling.
The IRR is just the discount rate that would make the net present value of a series of cash flows equal to zero. Or put it another way, the annualized effective compounded return rate of an investment (including both cash flow and sale proceeds).
Exactly. That says it best of all.
Using only COC is ignoring the financed amount which you are receiving a return on as well, or should. Go at it as a weighted %, COC and financed amounts in your IRR, each computed and viewed together as your WAR, weighted average return discounted. I agree to with Frank that you need to look at several cases as most like to paint a rosy pictured and get excited, it's a rush.
Regardless of how complicated you make it, what you find before you buy will not be what it was a year later. Doing some due diligence is a good thing, don't get carried away or be disappointed later.
And yes, use your figures, not from any third party as you'll be looking at apples to apples as I mentioned. :)
The IRR is just the discount rate that would make the net present value of a series of cash flows equal to zero. Or put it another way, the annualized effective compounded return rate of an investment (including both cash flow and sale proceeds).
And your discount rate being the opportunity cost of alternative investments having similar capital requirements, risk and management required.
You can get all the brain damage you enjoy right here LOL.
Hi @Account Closed
I find your method interesting! Could you possibly explain with an example to help me understand your method of evaluating leveraged investment properties better? Much appreciated!
Gautam
@Gautam Venkatesan Its quite simple. Lets say the purchase price is $50K. And you can rent it for $800. If you put 25% down you have a loan of 37,500. I can get a 10 year note for under 4% but lets call it 4% for easy math. So payment would be about $379/month. Using the 50% rule (which works really well for my market and these rental ranges) you would have NOI of $400 and a mortgage payment of $379 leaving you a small positive cash flow of $20/month which is as good as break even. So what it says is that you can pay off your loan in 10 years at zero cash flow. If the house has zero appreciation, you have an asset worth $50K in 10 years (very conservative, should expect at least inflation level appreciation). To me this is the threshold of a good investment. You may choose to take a 15 year loan to give yourself some room but I analyze on a 10 year assumption. For giggles I did the analysis using a 15 year loan and if I add up principal pay down and free cash flows, at the end of 10 years its just about the same result.
Thanks for the explanation Anish.
Anish I'm on the same page with you. A portfolio lender I use follows the same method. They will give me 10 yr loans ammort on 10yrs if the property will cover it. The best properties are under 90k. Otherwise they won't cash flow
One real-world aspect of IRR to keep in mind is that it assumes that any cash thrown off can be reinvested for equivalent returns (it indicates a compounded return). So for example, if you have a rental property that throws off cash, and you can't figure out a way to reinvest that cash with equivalent returns as the original investment, your IRR will be indicated as higher than what your true returns are.
Are you speaking of an annuity income? Same issue with notes, but principal received doesn't factor into the IRR. Rents seem to be the earnings returns are based on, the use of funds after receipt isn't factored into an IRR equation. Not sure I understand "thrown off". Late fees, residual fees or the income stream received? We either estimate for future returns or measure historic rents from actual receipts. :)
Rents seem to be the earnings returns are based on, the use of funds after receipt isn't factored into an IRR equation.
Actually, IRR assumes that all cash flow is reinvested back into the investment (or into an investment with equivalent returns) for the duration of the project. You can't just take cash flow and spend it -- or put it into a project with a different return -- and keep the same IRR.
I agree with you, that it would not remain the same, not so much to the assumption that funds received must remain in the project evaluated, funds paid out or taken out can go to different areas that may not yield the same return, in that case you begin looking as the distribution of funds on weighted contributions and as Frank pointed out, the streams may change as well. A Project such as a grocery store will have different departments, each can be assessed individually or together. There may be moving parts within the analysis and you can account for different rates or funds taken out. I agree too that generally you're looking at a lump sum for a set term, not saying you're wrong as much as funds can be adjusted. :)
@Susan Gillespie - thanks for sharing the article! Pretty insightful stuff - and just bought the book he recommended at the bottom of the article.
COC is the annual cash flow divided by your basic investment
COC = Annual cash flow / basic investment
I hope this help.