ROI, IRR, and CoC are terms thrown around quite a bit in the world of real estate investing, often without much context and often without a full understanding of what they mean. Let’s bring some clarity to these terms so you can better compare different investments.
ROI stands for Return on Investment. It is a quick and dirty calculation of how hard your money is working for you. If you invested $100K into a project, and at the end of the holding period you receive your original $100K back plus another $100K, your ROI (a.k.a. your Total Return) is 100%. For simplicity, we assumed there was no cashflow, and you received all of your returns at the end when the property sold. In this case you have effectively doubled your money. Another version of this is known as the Equity Multiple which in this case is 2X or a doubling of your equity.
IRR stands for Internal Rate of Return. It can get somewhat complicated mathematically, yet basically, it is a measure of how hard your money is working for you considering the time value of money (TVM). In multifamily, it considers cashflow from two sources:
- Cashflow generated through rental and/or other income, if any.
- An equity lump sum, upon the sale of the asset.
It differs from ROI, Total Return, and Equity Multiple, in that it factors when you invest and when each portion of the profit is received. Think of it as calculating the “compound interest” you are earning on a theoretical loan. It provides you a way to compare, “apples to apples,” the proposed project to other projects you are considering investing in as well as your cost of capital (if you have costs associated with the funds you’re investing). This applies if you consider a loan (i.e. a HELOC or refinancing a rental property) to invest the proceeds in a deal. This is an example of borrowing cheap money and investing it at a higher yield. For a project to generate a profit for you, your IRR needs to exceed your cost of capital.
CoC or Cash on Cash Return is a measure strictly on the cashflow a project generates and doesn’t consider the equity from a sale of the property. If you invest $100K and it generates $5K a year in cashflow the first year, that first year’s Cash on Cash Return is 5%. Sponsors will typically provide an Average Annualized cash on cash return which considers all of the cashflow the property generates from rental/other income and then divides it by the projected holding period in years.
This is because the cashflow is typically lower or absent in the first 6-12 months and ramps up as the sponsors execute on the business plan and increase the performance of the property. That is if the project’s goal is to generate cashflow at all. Some deep value add (heavy renovation or ground up construction) projects may not even have a cashflow component to them meaning they intend to provide one large distribution at the end rather than a quarterly distribution followed by a large one at the end.
This metric tends to be more important to investors that are looking to generate a steady stream of passive income. It is less important to investors who already have/make a ton of money and are just looking to grow their nest egg or are investing through a tax advantaged entity that they plan to retire on. For instance, if you are investing through a Self Directed IRA or 1031 Exchange, and you aren’t of retirement age yet, you generally can’t or wouldn’t want the cashflow to live on right now.
One metric is not superior to the others and each provides a unique insight into the performance of a property. Each is a piece of the puzzle that can bring clarity to how attractive a deal is to you, depending on your needs.
So there you have it, ROI/Total Return for an at a glance, IRR to account for the time value of money and compare cost of capital, and CoC to measure cashflow. Now, you know more than most about what these terms actually mean and can bring them up at your next cocktail party. 🙂
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Kelsie Mans-Ray
KMR Multifamily Acquisitions / Syndicator
NOTE: This information is of a general, educational nature and may not be construed as tax, financial, or legal advice pertaining to a specific offering, exemption or situation.Â
