Key Metrics for Evaluating Commercial Real Estate Investments

Quick takeaways:

• Several quantitative metrics are key to evaluating the performance of real estate investments.

• Different real estate investments have different goals or objectives. Key metrics can help investors compare investments on an apples-to-apples basis.

• Not every metric matters equally to every investor. Investor goals and timelines may help determine which ones to focus on.

Key Real Estate Investment Metrics

It’s widely recognized that real estate investment has the potential to produce qualitative benefits, such as improving a community by creating a great place where people want to live, work, or play. In another article we’ll dive deeper into various ways real estate investment can improve neighborhoods and lives.

The focus here is on key quantitative real estate metrics. Professional real estate investors generally consider these metrics among the most simple, straightforward ways to measure the financial performance of private real estate investments.

Internal Rate of Return, or IRR

The internal rate of return, or IRR, of a private real estate investment is the total annualized return on an investment over the life of the investment. The return includes any cash distributions (akin to cash dividends) and any appreciation derived at the time a property is sold or the investment is otherwise fully cycled. IRR can be expressed on a gross or net basis — gross IRR reflects total returns before fees and carried interest, while net IRR reflects what investors actually receive after those deductions.

Example: IRR is a complex financial calculation that requires an understanding of net present value. This example from JPMorgan shows how an initial equity investment of $1,000,000 produces an IRR of 7.58% over the five-year life of a multifamily property investment.

Equity Multiple

The equity multiple of a private real estate investment measures the investment’s total return relative to the initial equity invested. It’s not annualized to reflect the time value of money, but stated as a ratio that is calculated after an investment has been fully realized. Very simply stated, it measures how much cash an investor got back relative to the amount of cash invested.

Example: An investor makes a $50,000 investment in a mixed-use property. Over two years, the investor receives $8,000 in cash distributions, and then after the property is sold receives $60,000 back – his initial investment plus $10,000, reflecting a 20% gain on the investment at the time of sale. So, the investor receives $68,000 total. $68,000 divided by the initial investment of $50,000 equals 1.36x, which is the equity multiple. Said another way, the investor walks away with 136% of his initial investment.

Cash-on-Cash Return, or Cash Yield

The cash-on-cash return, or cash yield, of a private real estate investment is the annualized rate of return represented by any cash distributions paid to real estate investors on the equity invested in an individual property or diversified fund. The cash yield of a real estate investment could be compared to a stock dividend or the yield on a bond.

Example: An investor makes a $50,000 investment in a retail property. In the first year, he receives cash distributions totaling $4,000. $4,000 divided by $50,000 equals 8%, which is the cash-on-cash return, or cash yield.

Appreciation and Capital Gains

Income-producing commercial and multifamily real estate, like single-family homes owned by individuals and families, has the potential to appreciate in value. Appreciation over the purchase price, less the cost of any improvements, represents a capital gain.

Example: An investor makes a $100,000 investment in the purchase of an income property. At the time of sale, the investor’s stake in the property sells for $120,000. The $20,000 gain is considered appreciation and, for tax purposes, a capital gain.

Passive Losses Including Depreciation Deductions

Cash distributions and appreciation are the primary ways investors make money in commercial and multifamily real estate investing.

Real estate investments can also generate losses known as passive losses. In short, these are losses from activities in which a taxpayer does not materially participate. These losses may be tax-deductible by passive real estate investors, including against non-real-estate income. Thus, they can be valuable to some individual investors.

Calculating passive losses including non-cash losses from depreciation deductions can be complex, and their deductibility is subject to each taxpayer’s individual situation. Investors with questions about passive losses from real estate investing may want to consult their tax and investment advisors.

How to Compare Real Estate Investments to Each Other

Understanding the metrics discussed above can be helpful to investors as they think about building an investment portfolio that includes private real estate, and whether individual property investment opportunities, diversified fund investments, or both are right for them.

Armed with an understanding of key real estate investment metrics, investors may have a better framework for evaluating opportunities and comparing prospective investments to each other including by asking questions of project sponsors and investment managers.

The Relative Importance of Different Metrics Based on Investor Goals

Based on an investor’s personal goals and objectives, different metrics may be more meaningful than others. For example, a more patient investor who has a longer time horizon and doesn’t necessarily seek immediate cash yield may be more likely to favor an investment that isn’t likely to generate distributions in the short term but has the potential to generate significant appreciation over the medium or long term as the asset is constructed and stabilized in the case of new development, or acquired and improved in the case of acquisitions.

Conversely, an investor looking for cash yield may be content to sacrifice potential appreciation to one extent or another if the current yield on their private real estate investments meets their personal investment objective.

Understanding these metrics is a useful starting point, but no single number tells the full story of a real estate investment. Reviewing these figures alongside a financial or investment advisor can help investors evaluate opportunities more confidently and build a portfolio that reflects what they actually want to achieve.