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Posted about 4 years ago

IRR and Cash-on-Cash and Equity Multiple, Oh My!

Multifamily investors use many metrics to compare properties and choose the best deals. Some of the most common metrics are internal rate of return (IRR), cash-on-cash return, and equity multiple (EM). What do these metrics mean, and how can you use them to determine if a property is a good deal?

Cash-on-Cash Return

Cash-on-cash return is a simple metric that an investor can use to quickly compare different investments. The formula for this metric is (Pre-tax cash flow / Total cash invested). For instance, if you invested $100,000 in a property that cash flows $8,500 in a year, the cash-on-cash return would be 8.5%. You can also use this metric to approximate how much cash you need to invest to generate a certain level of income, which is helpful for retirees or people living on passive investment income. If an investor wanted to generate $75,000 of passive income before taxes from investments that generate an 8% cash-on-cash return, the investor would need to invest $937,500.

The biggest limitation of the cash-on-cash return metric is that it only works for a given period of time, usually one year, so it does not account for the time value of money. If the example above returned $8,500 after two years instead of one year, the cash-on-cash return would still be 8.5%, but the investment would be worse than a similar deal that provided the return in one year. It is also important to note that investments with higher cash-on-cash returns are usually riskier, so an investor has to balance his or her risk tolerance with the potential return.

Internal Rate of Return

Internal rate of return is a more complicated metric that includes the time value of money. It helps to show the profitability of an investment of the life of the investment. In multifamily investing, operators often plan to own a property for five, seven, or ten years, so IRR can show the return over that period. As an example, take an investment of $100,000 that returns $25,000 in years one and two, and $75,000 in year three. The IRR for this investment would be just under 10%. If the same investment ended in year two with a return of $100,000, the IRR would be 13%. The IRR is higher even though the amount of money returned is the same because the second investment returned the money in less time.

The IRR metric also has its limitations. Since the return is just a percentage, it does not specify the amount of money returned, which can make smaller, shorter-term investments seem better than larger, longer-term investments. For instance, an investment of $500 that returns $250 in one year has a higher IRR than an investment of $2,000 that returns $500 in one year, even though the second investment produces more money. If it is possible to invest in either investment, the second may be preferable. Another limitation is that the metric does not specify when money is distributed. It is possible to have two investments with the same IRR, and one provides the whole return at the end of the investment’s life, while the other provides annual distributions. Investors looking for passive income would prefer the investment with annual distributions, so that they could live on the income.

Equity Multiple

The equity multiple is a simple metric that shows the amount of money returned. Its formula is (Total profit+cash invested / Cash invested). An EM of 1x means that the investment broke even; it did not generate a profit, and it did not lose any money. An EM above 1x means that the investment is profitable, and the multiple tells you how much money the investment produced. If a $100,000 investment has a profit of $50,000, the EM is 1.5x.

The main limitation of the equity multiple metric is that is does not account for the time value of money. An investment could have an EM of 2x, but if it takes 10 years to produce that return, it may not be appealing compared to an investment with an EM of 1.5x over 5 years. For this reason, EM complements IRR as EM shows the total cash returned and IRR shows the time value of the money invested.

Which Do You Use?

So, which metric should you use? You should use all of them, and multifamily investors should provide all three of them in their investment summaries. The investment summary often provides cash-on-cash return for the cash flow in each year the property is held, and the IRR and EM for the profits from the entire investment period including cash flow and the sale of the property. It is important to note that these metrics are projected returns, and are not guaranteed. They also do not include other factors in an investment, such as the experience and ability of the deal operators, and the risks of the property or market. They do provide a way to quickly evaluate and compare different deals and their expected returns to help determine which may be best for you.



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