Syndication Return Metrics Series: 4 Metrics You Need to Know
As I speak with investors about commercial real estate syndication or current and upcoming deals in our pipeline, I often find us discussing common return metrics that are present in almost every syndicated offering. As you consider an investment in this niche or begin your journey to syndicate deals yourself, you must know the common metrics and how they’re used. I will give a high-level overview, so that everyone reading can follow along, of what I believe to be the four most common return metrics. With each one, the higher the number, the more desirable the investment is for all parties involved.
Preferred Return (pref)
The preferred return is a percentage target to be paid to limited partners before general partners. In other words, a percentage return on their investment before the general partner takes a single dollar. It is not a guarantee, but it is about as close as you can get to one. Typical preferred returns are in the 7-8% range for multi-family and self-storage, and 8-10% for manufactured housing communities. Additionally, the pref should be cumulative or it should “rollover.” This means that in any year your pref is not met, it is added to the pref of the next year.
Example: An 8% pref on a $100K investment would indicate that the limited partner(s) will earn $8K before the general partner earns anything. Take this same example and say that the limited partner only earns 5% in year one; if cumulative, this would mean that the limited partner is now owed an 11% pref in year 2 (8% year 2 + 3% not met from year 1).
We find the preferred return, including its cumulative nature, to be extremely important in our offerings. It shows alignment and ensures that we, the general partner, are not making a single dollar unless we and the asset perform.
Cash on Cash (CoC)
The cash-on-cash is a metric often used in real estate transactions to calculate the cash income earned on the cash invested in the property. Essentially, it shows you how hard your money is working for you. It is typically calculated on annual basis, so you can easily calculate either the CoC as a percentage or the dollar amount earned, given the other by using the formula cash on cash = return amount / invested capital.
Example: Assume you make a $100K investment and earn cash distributions from that investments equal to $8K in year 1. This would make your CoC 8% (8,000 / 100,000 = .08). Alternatively, imagine that you are considering making an investment into a syndicated commercial real estate property and the general partner is projecting a 9% CoC. You know that on a $100K investment, you would earn $9K/year (100,000 x .09).
The CoC in commercial real estate is often stronger than that of other asset classes like the stock market or single-family homes, even during market downturns historically, which is why we are bullish on the asset class.
Internal Rate of Return (IRR)
The internal rate of return is technically defined as the discount rate that makes the net present value of all cash flows from a particular project equal to zero. Put simply, it is the average yearly return of a project taking into account the time value of money. The calculation of the IRR, however, cannot be put so simply. Because it uses more advanced mathematical concepts like sigma and summation notation, the average investor is best off using an automated formula. You can find and example of how to calculate IRR using Excel here.
This is a very useful and often used metric because, as we know, a dollar today is more valuable than a dollar tomorrow; the IRR gives us an investor friendly look at this. Typical IRR across our asset classes (multi-family, self-storage and mobile home parks) is 16-24%. Of note is the fact that these are projections, and we always remain conservative in our underwriting / projections, thus we’ve been able to frequently provide higher realized returns to investors.
The equity multiple is the total cash distributions received from an investment divided by the total equity invested. In other words, it is the number that you can multiply your initial investment by to predict the total dollar amount that you will have in your pocket, including your initial capital, by the end of the deal.
Example: You invest $100K into a syndicated self-storage facility. The general partner projects a 2.2x equity multiple. This would imply that you will have a total of $220K (100,000 x 2.2) by the end of the holding period. Remember, this includes the return of your initial capital, so you’ve gained $120K. Conversely, take that same $100K investment and assume an $8K distribution for 5 years as well as a profit of $70K at the time of sale. You can calculate your equity multiple at 2.1x ((100,000 + 40,000 + 70,000) / 100,000).
Looking at our offerings, you’ll most likely see an equity multiple projection in the range of 1.6-2.6x. This is an easy to understand metric in terms of determining where an investor will stand at the end of the project cash wise, which is precisely why I like to highlight and discuss it with individuals interested in the syndication space.
The preferred return, cash-on-cash, internal rate of return, and equity multiple are all crucial metrics to understand whether you are an investor looking to allocate funds to commercial real estate, or an active real estate investor looking to get into the syndication space. As an investor or limited partner, they can help you quickly and easily vet deals. As a general partner, they can help you understand whether a project is worth the undertaking and how attractive prospective investors will find the offering.