Real Estate Investment Measures: AAR, Equity Multiple, and Cash on Cash Returns

Introduction:

At Faris Capital Partners, we aim to equip our clients with the insights and tools they need for fruitful real estate investment. In the ever-evolving world of private commercial real estate, it’s crucial to have reliable metrics to assess the performance of investments. This piece focuses on three key metrics: cash-on-cash return, equity multiple, and annual average return (AAR), offering a clear understanding of their uses and limitations.

You might find one or more of these metrics handy for your investment analysis.

Investing in real estate requires reliable measures to compare anticipated and actual returns. Private real estate is attractive to many investors as it can diversify their portfolio away from the public markets, thanks to its unique characteristics and potential for lower risk.

In the world of commercial real estate investing, professionals use various metrics to size up their investments. However, no one metric can capture the full picture of an investment’s potential. This blog breaks down these key metrics, explaining how they’re used and their limitations in private real estate. Keep in mind, that the accuracy of return forecasts depends greatly on the assumptions and models behind them.

Average Annual Return (AAR)

The Average Annual Return (AAR) is a formula used by real estate investors to measure the performance of an investment over its duration. It calculates the mean of yearly returns throughout the investment’s lifespan, offering a snapshot of what investors can expect, on average, each year. This metric is particularly valuable when evaluating potential investments, as it enables a quick assessment of the yearly returns an investment might add to a portfolio. Real estate deal alerts often include AAR to aid investors in making informed decisions.

How is AAR Calculated?

The AAR formula is straightforward:

Example:

Initial Investment: $100,000
Over a 3-year period, the investment yields the following returns:

Year 1 Return: 13% (calculated as $13,000 / $100,000)
Year 2 Return: 15% (calculated as $15,000 / $100,000)
Year 3 Return: 17% (calculated as $17,000 / $100,000)
These returns are derived from a combination of rental income, property appreciation, and other investment income streams. Each year, the investment generates a different return based on market conditions, rental income, and other factors influencing the property’s value and income-generating capabilities.

The AAR can then be calculated as:
AAR= (13%+15%+17%) / 3​

This calculation will provide the average return per year over the 3-year investment period.

The calculated Average Annual Return (AAR) based on the provided yearly returns is 15%. This means that, on average, the initial $100,000 investment would yield a 15% return per year over the 3-year period.

This example showcases how an investment can perform differently each year but still provide a solid average return, making it a potentially attractive option for investors seeking to diversify their portfolio with real estate assets. Understanding the AAR helps investors delve deeper into each investment opportunity’s specific business plan, ensuring informed decision-making.

Equity Multiple

The Equity Multiple is a straightforward yet crucial metric for evaluating real estate investments. It’s calculated by adding the total profit to the initial equity invested and then dividing by the initial equity. This gives investors a clear picture of their total return relative to their initial investment.

Example:
Faris Capital Partners recently financed a deal involving a 104-unit property in Largo. The project has a purchase price of $17,500,000 and a renovation budget of $1,800,000, aiming for a projected sale price of $31,300,000. With a projected profit of $10,000,000, the deal anticipates an equity multiple of 1.93x over a 5-year hold period.

Here’s a simplified look at how the equity multiple is calculated for this deal: If an investor makes the minimum investment of $100,000, the total return expected from this investment would be $193,000 ($100,000 initial investment plus $93,000 profit), giving us an equity multiple of 1.93x. This indicates that the investor’s total return would be nearly double their initial investment.

Cash-on-Cash Return

The cash-on-cash return is a popular metric in real estate that shows the cash income earned from the cash invested in a property. It’s a straightforward measure that reflects the annual return an investor gains from a property compared to the mortgage payments made in the same year. This metric is easy to grasp and crucial for evaluating the return on investment (ROI) in real estate.

Often referred to as the “cash yield” of an investment, the cash-on-cash return is calculated using a simple formula. It offers a quick snapshot of cash flows over the life of a project, averaged annually.

Example:
Consider this scenario: An investor buys a property that doesn’t generate monthly income for $1 million, making a $100,000 down payment and covering $10,000 in various expenses out of pocket. After a year, having paid $25,000 towards the loan, with $5,000 of that being principal, the investor sells the property for $1.1 million.

With a total cash outflow of $135,000 and a final cash inflow of $205,000 after paying off the remaining loan balance, the investor’s cash-on-cash return is ($205,000 – $135,000) / $135,000, which equals 51.9%.

The cash-on-cash return isn’t just about looking back; it’s also forward-looking, providing an estimate of potential cash distributions over the investment’s duration. However, it’s important to remember that this is not a guaranteed return but rather a projection to evaluate the attractiveness of an investment.

Holistic Approach to Real Estate Metrics

No single metric should be used in isolation when evaluating an investment’s potential returns. A comprehensive analysis using cash-on-cash return, equity multiple, and IRR will provide a fuller picture of an investment’s performance, taking into account cash flow timing, assumptions, and risk factors. It’s also crucial to assess the track record of the General Partner or Sponsor, as this can significantly influence the investment’s risk and return potential.

In summary, understanding Average Annual Return (AAR), Equity Multiple, and Cash-on-Cash Return is key for anyone looking to invest in real estate. These metrics offer valuable insights into an investment’s potential return, helping you make informed decisions. While each has its strengths, it’s important to use them together for a comprehensive view of your investment’s performance. At Faris Capital Partners, we emphasize the importance of these measures in helping our clients achieve their investment goals, ensuring a balanced and informed approach to real estate investing

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