How do you decide which real estate investments to pursue? Hmmm...perhaps its if the curb appeal is appealing? No...maybe if the finishes make you want to start? Or do you just use your gut feelings about that gut renovation? You're smarter than that and if you're planning to step up to the big leagues there are a few key metrics and performance indicators you should be using. Namely, COCR (cash on cash return), IRR (internal rate of return) and Equity multiple.
What Is Cash On Cash Return?
COCR(Cash on Cash Return) is a short and sweet metric for investors seeking passive cash flow. It is simply the net profit or cash returned on an investment divided by the initial capital or cash invested. It is the percentage of net profit you make on the amount you initially invested. If you invest $100 and make $50 each year, that's 50/100 = 50% COCR. In just two years you can make back all the money you invested! Sounds great doesn't it? If this was an indefinite investment - maybe, but most investments have a finite lifespan. What if at the end of those two years you exited the investment with only the $100 you made but did not get back the $100 you initially put in. You broke even....better than losing money. That's not so bad right? Well, we all know inflation makes a dollar today worth more than a dollar tomorrow. And at a minimum most investors want to beat inflation. This is where COCR falls short and IRR becomes relevant.
What Is IRR (Internal Rate of Return)?
IRR (Internal Rate of Return) is a complex formula that not only factors in your return on capital but also your return of capital. Getting more of your initial investment returned earlier results in a higher IRR. In other words, this metric is time sensitive and affected by how long it takes for the entirety of your initial investment to be returned. The sooner you have your initial investment returned the higher the IRR and the sooner you can reinvest that capital for additional gains.
*Rinse and repeat*
The IRR also considers the amount of return on capital. If there is a large return on capital this can offset a late return of capital, also supporting a higher IRR. Large returns can also offset negative years. IRR gives you a quick snapshot of the investment, summarizing what happens on average each year when all years are considered. To absolutely simplify this, a higher IRR means you can expect an early return of capital or a large return on capital. So how do you know which one is having more influence on your IRR? Are you making a lot of money on the investment or will you just be getting your money back quickly? And which one is more important to you? Well if you don't have the projected annual cash outflows the equity multiple may suffice.
What Is An Equity Multiple?
The Equity Multiple tells you how many multiples of your initial investment you will receive during the lifespan of the investment. This includes the total return of capital plus the total return on capital divided by the initial invested amount. If you invest $100, and make $300 and the initial $100 is then returned, you now have $400. $400/$100 gives you an equity multiple of 4. You have just multiplied your initial equity/ investment by 4. Good work, you've just made some real money! Feel free to pat yourself on the back! Together these three key metrics give you a good idea of how an investment is expected to perform and how much money you can actually expect to make. Be wary, higher returns typically carry higher risk. Deciding what opportunities to invest in can be difficult as a new investor. It would be great to just look at the numbers but there is so much more to consider.
This article was originally published on investwithare.com and is being reproduced here for the benefit of our members.