If you’re thinking of investing in a real estate syndication, you’re probably looking to evaluate the type of return you’ll receive on your investment.
But you may find yourself soon swimming in a variety of numbers and acronyms.
How do you make sense of what numbers mean what? And which return calculations do the savviest real estate investors pay attention to most often?
This guest post, submitted by site sponsor Ascent Equity, a real estate company founded by three physician investors, takes a look at these numbers and sheds some light on the situation.
In the discussion of real estate syndications, a lot of numbers and acronyms get thrown around. It’s hard enough for seasoned stock investors to keep track of these details. For most of us doctors, who have little to no financial education, it’s like looking at Latin, or maybe a diagram of the urea cycle—though I’m told a few docs still remember how that works, and I’m sure it’ll be useful someday.
Right now, though, more and more docs are investing in real estate syndications. This article summarizes briefly the returns on these investments. In the end, what we really care about is how much money ends up in our pockets, right?
It always bothered me that I couldn’t get a straight answer when I asked about returns, just “IRR this” and “EM that.” I kept hearing something about cash, too, but a lot less often than the other numbers. So, let’s break these concepts down one by one.
Internal Rate of Return (IRR)
IRR stands for “internal rate of return.” In layman’s terms, this figure is the return that investors receive taking into account how quickly it accrues. For example, if I borrow $10 from you and pay you back $20 the next day, chances are you’d be pretty happy with the transaction. However, if I borrowed the $10 and gave you back the $20 six months from now, you’d probably be less happy with it.
So, the first, quicker transaction would have a higher IRR than the second, slower one. Put another way, the IRR correlates positively with how quickly you receive your returns.
People usually don’t try to calculate this statistic because doing so requires spreadsheets and a bunch of equations. I think of it as the creatinine clearance of real estate syndications. I keep my eye on the IRR but don’t try to work it out myself.
I’ll provide a more concrete example in a moment.
You’ll see the actual equation below:
Equity Multiple (EM)
Another number that you often hear mentioned is the equity multiple or EM. This statistic represents the relationship between the money that you invest and the money that you receive back expressed as a multiple. In the previous example, in which I borrow $10 from you and return $20 to you, the equity multiple would be 2x.
Unlike the IRR, the EM doesn’t take into account the amount of time that elapses between an investment and the receipt of the return on it.
So, in the example, the first transaction would have a higher IRR with a 2x EM, and the second transaction would have a lower IRR with a 2x EM. I like to look at these numbers together because they can tell very different stories.
These statistics also provide a good framework for taking stock of your investment goals. Again, we all want to make money, but do you want your returns to be rapid so that you can make another investment or use your money for something else?
If so, you might want to focus on deals that offer a relatively high IRR, though your money has less time to grow, and the returns may not be as high as those offered by other deals.
On the other hand, if you don’t plan on using that money any time soon and don’t feel like looking around for another deal, an investment that offers the highest EM might be better for you irrespective of the IRR.
EM = Total Returns for Property/Initial Investment
Annualized Cash-on-Cash (CoC)
Lastly, I need to mention cash-on-cash investment. Many investors ignore the CoC, but it gives you an overall idea of a deal.
This statistic expresses your return on a yearly basis as a percentage of your investment.
If, for example, you invest $10 and earn $1 annually on that investment, you’re receiving a 10% CoC yield. Cash in your pocket is great because you take risks off the table.
Sometimes, you’ll see the “average CoC” mentioned. As you would expect, the CoC is usually lowest when an investment is made and increases over time as the operators execute their business plans.
The CoC is just the average of all of the years in which a deal is active. It’s an interesting number, but I like to see the CoC broken down by year to get an idea of how much money I can expect in my pocket.
Annualized CoC = Total Returns over One Calendar Year/Initial Investment
Putting It All Together
If you take away one thing from this article, it should be the importance of considering the IRR, EM, and CoC together. These statistics, ideally, provide an accurate picture of what you should be bringing in. Keep in mind, of course, that returns are not guaranteed.
These numbers are based on predictions and educated guesses by the sponsor/operator. Think of them as the X, Y, and Z axes on a graph: you can’t get the full picture without looking at all three together.
By now, you probably want to know which combination is the best.
The answer is easy: it’s high CoC, IRR, and EM at the same time, naturally.
Deals like this are about as common as jobs that offer great hours, pay, and benefits. More than likely, you’ll have to settle for a relatively lower value for one or another of these statistics depending on your goals.
I’ve found that the following general rules of thumb can be helpful when thinking about these issues.
- In most cases, a relatively high IRR or CoC correlates with a relatively lower EM because the money that comes back to you is no longer in the property working for you.
- The length of the hold period for a property correlates inversely with the IRR. This negative relationship exists because, again, the IRR measures how long it takes for you to receive the returns on your investment.
- Usually, the length of the hold period correlates positively with the EM because more time to execute the business plan means more time to increase the return on your money.
- The value of the CoC correlates inversely with the riskiness involved in a deal. If there is going to be a ton of extra money to give back to you, then the operators should be covering all of their expenses with a good amount left over.
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Here’s a bonus tip: because your concern as an investor is the money that comes back to you, it’s important to make sure that all of the numbers that you receive are net- or investor-level (as opposed to gross or property level). This way, all of the money that goes to the operator, including the fees, is accounted for. If in doubt, ask if the returns are net or not.
No deal is going to be perfect, with the ideal combination of IRR, EM, and CoC.
In another article, we’ll discuss what to do with these numbers and whether we can trust them at face value. We’ll also consider what represents a good IRR and EM in deals. Spoiler: IT DEPENDS—but on what, you’ll just have to wait and see!
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This post was submitted by Dr. Pranay Parikh, the co-founder and President of Ascent Equity Group which helps doctors invest passively to live the life they want. Ascent Equity Group was created with Dr. Peter Kim from Passive Income MD and Dr. Mithulan Jegapragasan, both instructors for Passive Real Estate Academy. Together they have helped 100s of doctors invest in real estate without the stress and demands of being a landlord.