Passive investing in real estate can be a great way to gain exposure to real estate without day-to-day management. For some investors, publicly-traded REITs are an easy entry point with high liquidity and are truly passive in nature.
Alternatively, for those that want more direct holdings in real estate, buying a single-family or small multifamily property is the first step; however, for some, even the oversight of a property manager can be more work than they wish to undertake. The third option is to invest in real estate through passive syndications.
Each form of investment will have its own financial metrics that are commonly seen. In this article, we are going to focus on those that are most commonly used in the private real estate world, specifically syndications and private real estate funds.
1. Preferred Return
A preferred return is a profit distribution preference whereby profits, either from operations, sale, or refinance, are distributed to one class of equity before another until a certain rate of return on the initial investment is reached.
The preferred return is NOT what the annual return or annual cash flow from your investment will be. While many sponsors will pay their preferred return current at a regular interval, this is not always the case.
For example: If you invest $100,000 in an offering with a 6%/annum preferred return, simple interest, you as the LP will receive 100% of the free cash flow until you have hit 6%/annum. The actual cash flow from the deal could be $3,000/annum, paid monthly, until sale at year five. Meaning, when the property sells, you would be due back $15,000 from the sale to catch up on your preferred return before the general partner would be eligible for any carried interest.
2. Cash-on-Cash from Operations
The cash-on-cash from operations return is the actual cash flow projected to be returned over a period of time divided by the initial investment you made. This calculation would not factor in any sale proceeds, but may or may not include refinances, depending on how the sponsor models.
To continue the example above, this deal would be reflecting a 3%/annum cash-on-cash return from operations or exclude sale proceeds.
3. Cash-on-Cash, Overall
Similar to cash-on-cash from operations, this calculation adds up all the distributions received during the investment and divides by the length of time owned. This is a simple interest calculation.
Let’s continue with the same example: $100,000 invested, $3,000 per year paid out over a five-year hold. When the asset is sold, the investors receive $150,000 in total sale proceeds. Investors in this instance received $165,000 back over the five-year hold, with $100,000 being the return of capital. To calculate overall cash-on-cash return: $65,000 divided by $100,000 divided by five years equals 13% average annualized cash-on-cash return, overall.
4. Internal Rate of Return (IRR)
The internal rate of return (IRR) is the annual rate of growth that an investment is expected to generate.
In more simple terms, IRR looks at the timing of all cash flows and applies a discount the further into the future any respective cash flow is projected to occur (or actually occur relative to initial investment when using actuals). IRR is ideal for analyzing capital budgeting projects to understand and compare potential rates of annual return over time.
The IRR calculation is complex and typically calculated in Excel. But the inputs are the same as the example above; All distributions and their dates, as well as sale proceeds and dates.
Using the example above, if you invested $100,000, received quarterly distributions equating to $750/quarter and final payout at the end of five years of $150,000, your IRR for the investment is 11%.
However, if a refi occurs and produces $30,000 at the end of year two while reducing the sale proceeds to $120,000, the IRR jumps to 13%. Or if the refi occurs at the end of year one, the IRR rises to 14%.
5. Equity Multiple
The final common financial metric is equity multiple, which is simply the total amount of distributions, including sale proceeds, added up, and divided by your initial investment.
Essentially, it’s how much money an investor could make on their initial investment. An equity multiple less than 1.0x means you are getting back less cash than you invested. An equity multiple that is greater than 1.0x means you are getting back more cash than you invested.
Using my same example: an investor in this deal who invested $100,000 and received $165,000 in total equates to a 1.65x equity multiple.
While these are not an all-inclusive list of various financial metrics, they are the most commonly used, both amongst sponsors and investors.