Return on Investment: What Metric Should I Use?
In real estate investing, there are a number of metrics that you can use to calculate the return on investment.
While some real estate investors prefer to focus on a single or a couple of metrics when investing in real estate, not all metrics are made equal. The different metrics that are used for calculating the return on investment have their own use, advantages, and disadvantages.
Some metrics are more useful than others in certain situations and depending on the type of real estate investment that you’re making. The factors which determine the best metric to use include the lifetime of the investment and the financing method that is being employed as well as the investment strategy that is being used.
Below are some of the most commonly used metrics for calculating the return on investment in real estate. We will be briefly explaining what each metric is used to calculate, how it is calculated, and what its limitations are.
The Cap Rate and the Cash on Cash Return on Investment
The cap rate and the cash on cash return on investment are among the most commonly used metrics for calculating the returns on a real estate investment. Both metrics are very similar in the way they are calculated, with the main difference between them being determined by the financing method that is being employed by the real estate investor.
The cap rate is a metric that is used to calculate the amount of income that a real estate investment will make in relation to the current market value of the investment property that you’re analyzing.
Related: How to Calculate the Cap Rate for an Investment Property
The cash on cash return, on the other hand, is used to calculate the return on investment based on the amount of income that an investment property generates in relation to the amount of actual cash invested in it.
Related: Real Estate Investing 101: How to Calculate Cash on Cash Return
As you can see, the main difference between the two metrics is that the cap rate does not take into account the method of financing that is being used. The cap rate assumes that all of your investment property purchase was made in cash, and the total current value of the investment property will be included in the calculation instead of the actual amount of cash invested in it.
The cash on cash return, however, will only take into account the amount of actual cash invested in the property. If you’re financing your purchase through an 80% mortgage, for example, the cash on cash return calculation will only include the 20% down payment that you’ve paid in cash.
Both metrics are generally used to determine the percentage of the property’s value or the percentage of the cash invested that the investment property will generate in returns on an annual basis.
Here are the formulas used for calculating each of these metrics:
Cap Rate = (Net Operating Income/Current Market Value) x 100
Cash on Cash Return = (Net Operating Income/Total Cash Invested) x 100
These metrics, however, have limitations. The main limitation is that these metrics rely heavily on the NOI as an average over the period of the investment. But, as most real estate investors know, the cash flow of an investment property can vary widely from one year to another. A real estate investor needs to thoroughly understand the business plan and the real estate market’s dynamics to come up with a more accurate calculation of these metrics based on the variables over the duration of the investment.
Related: Is Capitalization rate or Cash on Cash Return the Better Real Estate Metric?
Equity Multiple Return on Investment
The equity multiple is a metric used in real estate investing for calculating the return on investment based on the ratio of investment returns to the paid-in capital. The equity multiple is somewhat similar to the cash on cash return metric, with a formula that is also very simple to use.
The formula for calculating the equity multiple is as follows:
Equity Multiple = Cumulative Distributed Return/Paid in Capital
To give you an example, let’s suppose that you’re investing $40,000 in a rental property, and you earn $30,000 in rental income over the hold period of the property in addition to the return of the initial investment when the property is sold.
Equity Multiple = ($40,000 + $30,000)/$40,000
Equity Multiple = 1.75X
This value means that at the end of your investment, you should have made a total profit of 1.75 the initial value of the investment or the amount of money you’ve invested in the property.
A higher equity multiple, however, doesn’t necessarily mean that you’re making more profit. A higher equity multiple might mean that you’re making more money but over a longer period of time. This is, in fact, the biggest limitation of the equity multiple metric – it does not account for the time factor.
On paper, an equity multiple of 2.5X, for example, might sound great. But in reality, it could mean that the investment will need 20 years to produce that return, a period in which you could be investing this money elsewhere.
This is why the equity multiple is a return on investment metric that is best used in combination with the internal rate of return.
Internal Rate of Return on Investment
The internal rate of return is one of the more challenging to use metrics to calculate the return on investment in real estate investing. The internal rate of return is essentially an annualized rate of return on investment, which allows you to get a better understanding of the distribution schedule of your returns over the hold period of the investment property.
The internal rate of return is most commonly used in analyzing real estate crowdfunding investment opportunities. It is typically expressed as a percentage, and from a very general point of view, you could say that a higher internal rate of return means higher profits and a higher risk, while a lower internal rate of return means a lower profit and a lower risk.
The formula for calculating the internal rate of return looks like this:
If you’re not a fan of complex math and equations, fear not! Most real estate investors use Excel or special calculators to calculate this value.
Another way of expressing the IRR is:
IRR = the interest rate that makes the NVP (Net Present Value) equal to zero
In essence, if you use the IRR, this is what the results of your calculations will look like:
Using these results, a real estate investor would be able to understand how the return on investment will look like over the hold period of the investment property and until the property is sold again. This is by no means a sufficient explanation of the metric, and there is much more to it than that. This is only to show you why the IRR is used in real estate investing, and how it is calculated.
To get a better understanding of the metric and how to use it for calculating the return on investment, you should do your own research and learn more about the metric, as there is much more to it than what is mentioned in this article.
Related: Become an Expert on Internal Rate of Return in Real Estate Investing
Alternatively, you can hire a financial expert or a real estate agent to calculate the value for you and help you get a better understanding of the results and how you can use them to make better investment decisions.
Bottom Line
In order to become a successful real estate investor and achieve the highest profits and return on investment, it is important to learn about all the different metrics used for calculating the return on investment and to be able to determine the best metric to use in each situation or the combination of metrics to better understand your returns and make better investments.
Since the cap rate and the cash on cash return are the two most common metrics used in real estate investing, Mashvisor uses these metrics for the assessment of the investment properties that are listed on the platform, providing the user with readily calculated results to help you search for and find investment properties in the least amount of time and based on accurate results and calculations that can determine the general value of the investment.
