Measuring Returns (sans Rose-Colored Glasses) in Real Estate Investments

No one goes into an investment thinking they are making a bad decision. They are presented with glossy presentations that focus heavily on how strong returns could be.  And many investors rely on those numbers to guide their decision-making. 

However, few investors peel back the layers and get an in-depth, accurate understanding of the underlying mathematics driving those projected returns.  When you are deciding where to put your money and how to make it work for you, you want to make the most intelligent and most informed decision possible.  Let’s get right into it.  


More likely than not, you are going to be reviewing investment opportunities from various sponsors/operators.  Each will provide different variables and present data with their own flavor of nuance, so we are not talking about apples-to-apples comparisons here.  However, you should be able to understand the key performance metrics (KPMs) that are consistent across each investment type, as well as the formulas used to calculate each. 

Case in point: everyone talks about return on investment (ROI), but there is no clearly defined definition for how to calculate it.  To get a more robust picture of potential returns, consider evaluating some of these additional performance metrics as well: 

Internal Rate of Return (IRR)

IRR is arguably the most common KPM you will see referenced in an offering document.  It is a financial calculation that accounts for all of the cash flows related to a project’s inflows (rent, sales price, etc.) and outflows (expenses, purchase price, debt payments, etc.). All inflows and outflows are assigned a time period over the life of the project.  The IRR formula calculates the discount rate that creates a net present value of all the cash flows that is equal to zero. 

This discount rate is the IRR, or the annual return that makes the net present value of the cash flows equal to zero. (Sounds a bit complicated, right? Luckily, Excel has a formula you can use to make the calculations a bit easier.)  

The result of all this math is the expected return over the life of the project, expressed as a percentage.  The IRR percentage will give you a reasonable basis to compare one investment to another, but you need to also understand the major assumptions that drive this number, including:  

  • Lease rates and growth assumptions
  • Expense budget and growth assumptions
  • Property taxes
  • Exit cap rate 
  • Interest rate

Equity Multiple

The equity multiple is the result of adding up every dollar received and dividing it by the original investment amount.  A higher multiple is obviously better, and anything less than 1 is a loss.  However, the equity multiple does not factor in the time value of money.  

An equity multiple of 3 that takes 30 years to achieve is not as valuable as an equity multiple of 1.5 that is achieved in one year.  Therefore, evenly evaluating this metric across multiple investments requires taking into consideration the expected investment duration or hold period.

Cash on Cash

Cash-on-cash return is the annual amount of distributable cash divided by the total cash investment.  It is often presented as an average of the expected distributions over the investment hold period.  (Pro tip: if evaluating investments based on this metric, focus on how much cash the investment will generate comparable to a bond yield.)

This metric may be skewed by using too much leverage, employing periods of interest-only debt, or underestimating expenses, so it is important to have a full view of the assumptions and risk embedded in high cash-on-cash return projections.  

Current Return

Rarely presented in offering documents but still important to note, the current return can help compare investments that utilize interest-only debt alongside those using traditional amortizing debt.  Similar to cash-on-cash return, current return is calculated by adding the annual distributable cash and the amortizing debt payments then dividing by the total cash investment. 

It is essentially a comparison metric that can eliminate any distortions or inflations caused by the inclusion of interest-only payment periods.

Embrace Your Inner Skeptic

As an investment professional, I have reviewed hundreds of presentations and financial models. Many had a clear optimism bias in the form of expected rent growth, occupancy, bad debt, lower expenses, interest rates, and/or exit cap rates.  These operators were not trying to pull a fast one on me, they were just looking at everything as glass-half-full. 

Optimism is a good thing 99% of the time.  But when making investment decisions, being a little wary goes a long way.  Ask your sponsors how they handle downside scenarios, disruptors, or external market forces.  Get them to take the rose-colored glasses off before you sign on any dotted line.

In short, it is your job as an investor to (1) understand the range of outcomes and (2) how the assumptions may influence those outcomes and introduce variability and risk into the return projections.

At Cira Capital Group, we help busy professionals diversify their traditional investment portfolios by creating private real estate funds, pooling investors’ capital with our own, and investing with world-class operators.

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