The world of multifamily investing can seem intimidating at first glance, and something you don’t want to jump into without proper preparation. As a potential investor, your success depends on having a comprehensive understanding of the numbers involved in these investments. Luckily, doing that doesn’t require an advanced degree or a complicated algorithm; all you need is knowledge of the fundamentals and some basic investment wisdom. In this blog, we will discuss the essential return metrics for multifamily syndications.
Capitalization Rate
The capitalization rate, commonly known as "cap rate", is an important metric utilized by professionals in multifamily investing. It's a calculation that attempts to estimate the current market value of commercial properties by examining the ratio between net operating income (NOI) and purchase price. A low cap rate implies a higher price and a high cap rate implies a lower price. Low cap rate investments are considered less risky. The value of commercial real estate is based on the income generated from the property. Thus, the cap rate metric is used to compare to the value of other commercial properties in the market. A cap rate of 6% means the net annual income is 6% of the property purchase. For example, if you purchased a property for $1,000,000 and generates $60,000 in net operating income has a 6% cap rate.
Cap Rate = NOI/Purchase Price
Cash on Cash
A critical metric for multifamily investors is cash on cash (CoC) return. It provides insight into how much operating income an investment is generating compared to the initial capital investment. In short, cash on cash provides investors with an idea of how much of their capital will be returned to them annually before taxes. For example, if you invest $100,000 into a property and receive an annual distribution of $9,000, then your cash on cash return is 9%.
Cash on Cash = Annual Cash Flow from Operations/initial Investment
Internal Rate of Return
The universal measure to assess returns on multifamily and other alternative real estate investments is Internal Rate of Return (IRR). The IRR analyzes all cash flows, including cash flows from operations and the sale, over the life of the investment. It factors in the time value of money, which is the concept that money is worth more today than in the future. Therefore, future cash flows are discounted to today’s present value. IRR determines the annual growth rate that an investment is expected to generate. The higher the IRR, the higher the returns. For example, if the IRR is 15%, then this means your money will grow 15% per year.
Annual Average Return
The annual average return (AAR) is similar to the IRR, but more simplistic. Both measure the performance of an investment over a period of time. The main difference is annual average return does not consider the time value of money; thus, the annual average return will be higher than the IRR. This metric describes how much money an investment generates on average over the life of the investment, including both operating income and profit from the sale. For example, if an investment earns the following returns Year 1 – 5%, Year 2 – 10%, and Year 3 – 50%, then the AAR after 3 years is 21.7%. AAR = (5+10+50)/3
AAR = (Sum of All Annual Returns)/Total Years
Preferred Return
Preferred return is the minimum return distributed to limited partner investors before the general partners receive a share of the profits. The limited partners have preference to the first distributed cash flows up to this percentage. A preferred return can provide peace of mind for investors because they know they will get paid back first, which is a vital factor that draws them to the business. For example, an 8% preferred return or “pref” means you, as the limited partner, will receive an 8% annual return on your money before any other profits are disbursed.
Equity Multiple
Equity Multiple is the total return earned on investment relative to the initial investment. It’s measured as a multiple of the capital invested over the time of investment. For example, if you invest $100,000 and over a course of 5 years you received $80,000 in profit plus your total money invested, then your equity multiple is 1.80.
Equity Multiple = (Total Profit + Total Investment)/Total Investment
Debt Service Coverage Ratio
The debt service coverage ratio (DSCR) shows the property's ability to meet its financial obligations. It is a measurement of how well the property can pay back its annual debt payments. For example, a DSCR of 1 indicates that the property is generating revenue that can cover all its debt payments, while a DSCR of less than 1 implies the property generates insufficient cash flow to cover its debt obligations. In general, a DSCR of 1.2 is considered safe, but a higher DSCR indicates a property of better health.
DSCR = Annual NOI/Annual Debt Service
Final Take
Investing in multifamily real estate can be profitable, but it can also be challenging to assess the numbers unless you understand the fundamentals. Understanding the figures that drive real estate investments constitutes a crucial aspect of determining which properties offer the most potential rewards. As an investor looking to tap into the potential of this growing industry, the more you know about the above metrics, the better prepared you will be to navigate multifamily real estate investments successfully.
Are you an investor who wants to generate passive income? Consider investing in multifamily syndications. Investing in multifamily real estate is a great way to improve your financial status and you can do it passively through a syndication. To learn more visit www.shhequitygroup.com.
About the author: Tomond Jack is a real estate entrepreneur and syndicator who has over 20 years of investment experience. He is passionate about helping people expand their wealth through real estate.
Comments