3 Key Investing Metrics You Must Know!
When investors are evaluating deals, they will underwrite all kinds of scenarios by looking at items such as the property’s income, capital needed to close the deal, operating expenses, debt, or capital expenditures. To make sure the deal makes sense, investors will use a multitude of ratios to help them compare deals and fully commit to purchasing a property at the right price. Three main return metrics investors use are Cash-on-Cash, Average Annual Return, & Internal Rate of Return. Let’s dive in! (1). Cash-on-Cash Return (CoC): Formula: CoC = Cash Flow / Total Capital Invested Cash-on-Cash is a simple formula that looks at the annual cash flow (money left over after all expenses and debt have been paid) as a percent of the total cash invested into the deal. Total capital invested would include items such as a down payment, legal fees, or closing costs. Let’s look at a quick example below: Total Capital Invested: Down payment: $200,000 + Closing Cost: $10,000 + Legal Fees: $5,000 = $215,000 Annual Cash Flow (after all expenses & debt are paid) = $25,800 Cash-on-Cash Ratio = $25,800 / $215,000 = 12% You will see that after all the math is done, we are looking at a 12% annual return on our cash investment. This is great! Please keep in mind that this 12% only accounts for one year. It is important to have an average cash-on-cash return section to account for any changes in cash flow over the life of the investment. The investor can now take this number and compare it to other properties or even compare it to alternative investments. (2). Average Annual Return (AAR): Formula: AAR = (Total Return / Total Years) / Total Capital Invested There are many financial measures that can be used to determine the potential results of a property, but the average annual return is one of the best out there. It is a favorite to use because it accounts for cash flow, appreciation, and amortization. This helps paint a much more comprehensive picture for the investor and lets them see what the return will look like for the entire life of ownership. To understand this formula, let’s break it down by building on the CoC example above. Let’s assume you bought a property for $1,000,000 and then sell that property for $1,250,000 5 years later. Total Capital Invested: $215,000 Acquisition Price: $1,000,000 Sale Price: $1,250,000 Sale Proceeds (Appreciation): $250,000 Total Return: Profit from Sale: $250,000 in year 5 + Amortization: $76,419 over 5 years + Annual Cash Flow: $25,800 x 5 years = $129,000 Time: 5 Years Average Annual Return = ($455,419 / 5 Years) / ($215,000) = 42% Now we know our average annual return of 42%. Most investors would jump at any opportunity to have this type of return. What this 42% tells us is that the investor will more than double his or her money after 5 years. Not too shabby; now go make sure to add this powerful metric to your next property analysis! (3). Internal Rate of Return (IRR): The internal rate of return is a very well known, sophisticated metric that is widely used to evaluate a potential property or any project. The power behind this formula is that it considers the magnitude and timing of cash flow. The IRR formula is not as simple as the CoC or AAR formulas so when investors calculate this metric, they will either use Microsoft Excel or a financial calculator. For that reason, an example won’t be laid out like with the metrics above. Despite a confusing formula, let’s try to simplify the meaning of IRR and why it is so useful. What IRR does is account for the time value of money which says that a dollar today is worth more than a dollar a year from now since you can reinvest that dollar today and start earning interest. IRR at its core provides a more accurate annual return for the life of the investment based on the amount of cash flow you receive as well as when you receive it (one year from now versus five years from now). This is a very effective way to analyze an investment property and compare other types of investments. At the end of the day, these three measures of returns are helpful in determining a properties worthiness. Please note that no single metric should be taken as gospel for buying a property. It is important to look at the full picture and evaluate multiple metrics before deciding. Performing proper due diligence and buying right is crucial to owning a successful investment property.