What are the potential returns when passively investing in multifamily syndications? What are the key metrics to pay attention to and how are they calculated?
It’s important to know the answers to these questions so that you can better understand and evaluate different investment opportunities.
To tackle these questions, I review the three metrics used to measure returns: cash-on-cash, average annual return and IRR.
I explain how each of the numbers are calculated and how they might change over the life of your investment.
I’ll also give you some rules of thumb of what kinds of returns you can expect.
Let’s get right into it … watch the video or keep on reading:
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The first metric we can use to evaluate real estate earnings is cash-on-cash return. It is calculated by taking the annual cashflow and dividing that by the amount of money invested. Here’s the formula:
For example, let’s assume you receive a distribution of $10K and you invested $100K in the property, then your cash-on-cash return is 10%:
If you invested in a value-add deal, the cash-on-cash return may be lower the first year as the sponsor team is working to complete the necessary renovations and get tenants in the units. But by Year 2, you want to see things stabilize, meaning occupancy has reached at least 90% and rents have increased to market value. At that point, you should expect a cash-on-cash return of around 8% for Class B properties and higher for Class D properties.
Average Annual Return
The next measure of real estate revenue is what we call the average annual return. Add up your total earnings over the life of the investment (both cashflow and profit from the sale) and divide that by the amount invested. Then divide THAT by the number of years your money was kept in the deal, and the result is your average annual return. Here’s the formula:
Let’s say you invested $100K and made a total of $75K in cash flow distributions and profits over 5 years. Now divide that by your investment of $100K. Take the resulting 0.75 and divide that by 5 years, and you have an average annual return of 15%. Here’s the math:
A solid average annual return is anywhere between 14% and 18%, depending on factors like market and asset class. For instance, the return will be on the lower end if you are investing in growth markets like Atlanta and Dallas. You can also expect a slightly lower return for a superior asset class, as B and B+ properties come with less risk. Conversely, investments in secondary or tertiary markets should have a return on the higher end, as should class C buildings.
Internal Rate of Return
The Internal Rate of Return or IRR is the most accurate way to compare one investment vehicle with another. It also happens to be the most complex. Microsoft Excel has a function to help us calculate the internal IRR, taking cashflow distributions and proceeds from a refinance or sale into consideration as well as the net present value or NPV. (NPV accounts for the fact that money loses value over time due to inflation, for example).
Consider the following example:
In the above scenario, the investors put $2.9M into the deal. After figuring in cashflow distributions and profits from a refinance in Year 2 and a sale in Year 5, the internal rate of return is a very strong 19.95%. Strong because your target IRR range is 13% to 17%. (Notice that this is slightly lower that the targets for average annual return thanks to net present value. Darn inflation!) Once again, the heavier the value-add, the higher the risk, the closer you want to be to a 17% IRR – but IRRs at 13% for nicer (Class B), more stable assets are excellent.
A Real-World Case Study
Let’s put it all together by evaluating the returns of an investment opportunity. In the case study below, you see the overall returns for a typical value-add multifamily investment. As you look at the first row, notice that $2.9M was invested initially, but after the refinance at the end of Year 2, only $876K in capital remains in the deal (that’s because the majority of the investors’ principal was returned from the refinance). Also important to note is the dramatic increase in cashflow from Year 1 to Year 2 as the property is stabilized.
The row tracking cash-on-cash return indicates a similar jump from Year 1 to Year 2 as occupancy and rents increase. But then there’s significant growth AGAIN in Year 3 because the refinance returned 75% of the investors’ capital (as illustrated in the row labeled Return of Member Capital), and less money in the deal translates to a higher cash-on-cash return. This pushes the average cash-on-cash return to 21%, due in large part to the refinance.
You will notice similar leaps in average annual return after the refinance in Year 2 and, of course, the sale in Year 5. Perhaps most impressive, though, is the 20% IRR—which is well above our target range of 13% to 17%.
As you compare potential investments, ask syndicators about these key metrics—cash-on-cash return, average annual return, and internal rate of return—and ensure that their projections fall into the appropriate ranges. This gives you an easy way to compare deals and make informed decisions about who to trust with your money.
But don’t just chase the return! Make sure the sponsors are being conservative in their projections. Here are some things to look for:
· Are there plenty of reserves at closing?
· Are the reserves increased over time by taking them out of cash flow?
· Is there cash flow from day one and is long-term debt being used?
· How aggressive are the rent grown projections, and are they realistic?
· What are the assumptions for re-sale? Are they conservative or overly aggressive?
If you see conservative assumptions AND attractive returns, you might have a winning investment on your hand!
If you are interested in passively investing with us, I’d like to invite you to join our Nighthawk Investor Club.