To properly evaluate a real estate deal it is important to understand the key financial metrics that are used when describing the projected performance of a deal. Investors often have a number of competing deals to analyze and in order to decide on the most appropriate investment, a good starting point is to look at how each deal is projected to perform.
Like anything else in the real estate investing world, these are just projections and reality may deviate significantly from the projections. However, real estate has shown to keep up with or perform better than inflation over time and is typically less volatile than the stock market.
Cash on Cash Return
Cash on Cash Return (CoC) is probably one of the first metrics that an investor should pay attention to. This metric is the projected annual return on the capital invested in the deal and is expressed as a percentage. For example, if the investor has invested $100,000 into a deal and is earning $8,000 per year on that investment, then the CoC return is 8% annualized.
CoC is a good measure of how the deal will perform in the near-term. How does the return compare to alternative investments, such as safe investments in CDs and short term treasury bonds or more risky investments in startup companies or junk bonds? Investors have to decide if the risk-adjusted returns align with their goals.
Internal Rate of Return
The Internal Rate of Return (IRR) takes a series of cash-flow over a period of time and discounts them back to the present day. This formula can be used to compare different investments with irregular cash-flow to see how they compare. As money “today” is more valuable than in the future, a higher value is placed on cash-flow received sooner in the investment. So two investments with the same overall cash return may have different IRR if the returns are distributed differently.
IRR is a good way to compare two different investments.
Average Annual Rate of Return
Average Annual Rate (AAR) is just the average return of an investment over a set time period. If the investment is sold during the period, the gains from the sale are included in the AAR. This metric does not consider the time value of money like IRR does.
Equity Multiplier when used to describe real estate investing is the project multiplication of the investor’s initial investment. If the investment is projected to double during the hold time, the equity multiplier is 2x.
Net Operating Income
Net Operating Income (NOI) is calculated by subtracting property expenses from the gross income. This metric excludes debt service, capital expenditures, and depreciation.
Debt Service Coverage Ratio
Debt Service Coverage Ratio (DSCR) is the ratio between the NOI and annual debt payment. In other words, net operating income is divided by total debt service. Ideally, this should be 1.25 or higher, so there is plenty of income from the property to cover the debt service.
Capitalization RateThe Capitalization Rate (CAP) rate is calculated by dividing the NOI by the purchase price. So a $10,000 NOI and a $100,000 purchase price is a 10% CAP Rate. The CAP rate is an expression of what an investor is willing to pay for a given stream of income. A lower CAP rate means higher purchase prices.