When evaluating different investments that would fall into the same bucket within your portfolio, it can be challenging to understand how they compare since they may have very different characteristic such as cash flow and time to completion (to know what your buckets are, you need to understand your personal investment philosophy). To help compare deals, it is often useful to use standard metrics such as the Cash on Cash return (CoC), the multiple of invested capital (MOIC), and the internal rate of return (IRR). However, figuring out the best deal isn’t as simple as just looking at those numbers, you need to understand both what they mean and what numbers are most important to you based on what you are looking for out of the investment.

When looking at the cash flow from a deal, the CoC is the most straightforward metric. It is simply the rate of return that you see on your investment during the year. For example, if you invest $100k in a deal and get $7k back in dividends the first year, your CoC return is 7/100 = 7%. This number is extremely useful when you are looking at a long term, buy and hold, deal as it gives you an indication of what you can expect to get out of the deal on a recurring basis. There are a few downsides of the CoC metric, however:

• It does not account for the time value of money. A dollar today is worth more than a dollar in 14 years, but the CoC return doesn’t account for that difference.
• It typically focuses on the operating income (ie yearly return) and does not incorporate any additional returns that may arise from outside of the regular operations. This means that it isn’t particularly insightful for deals where you would expect to see most of the profit from the final sale of the property, such as a development or major value add deal.
• It can depend a lot on the timeline being used to calculate the return. CoC is usually calculated as an annual percentage return over a 1 year time horizon. However, if the deal is expected to have a steep increase in cash flow over an initial holding period, the sponsor may calculate the annual return using an average of the expected returns. For example, if the projected CoC is 3% year 1, 5% year 2, and 7% year 3, the information may be conveyed as an average CoC of 5% over 3 years or it could be expressed as a range of 3-7%. That can be useful information if you care about the overall rate of return, but not so good if you are expecting 5% of your cash back in the first year.

A CoC return can tell you how long it will take to get your original investment out of the deal assuming there is no other activity (e.g. at a 7% return, you would get your original $100k paid back in just over 14 years). However, CoC should not reflect the return of your original investment. So if you put in $100k, held the deal for 10 years, and got cash distributions totaling $10k each year, that would be a 10% CoC return if you still have $100k in capital in the deal. If your capital account is $0 and you no longer have any ownership stake in the company, with no more distributions coming, you just gave the sponsor a 0% loan for a decade. You need to understand both the cash flow from the CoC return and when you can expect to get your original investment capital back in order to really understand your total returns.

The MOIC, also known as an equity multiplier, tells you how much money you should expect to receive over the lifetime of the deal. The MOIC is calculated by taking the full amount of all of the payments to you (including the final return of your capital) divided by your initial investment. For example, by the end of the deal, you are expected to receive a total of $175k in distributions on an initial $100k investment, then your MOIC is 1.75. Obviously, any investment with an MOIC less than 1 is not likely to be a good one since you are getting back less than you put into the deal – in other words, you lost money. MOIC gives you an idea of how much you can increase your wealth over the course of the deal, but it doesn’t give you any insight into the distribution schedule. It is also important to keep in mind the expected timeframe of the deal as a deal that provides the same MOIC over a shorter period of time is going to allow you access to those returns faster and allow you to increase the velocity of that money. A deal that you put $100k into and pays you $5833/yr for 30 years has the same MOIC (1.75x) as one that pays you nothing for 5 year and then gives you $175k in one lump sum, however, most investors focused would consider the second deal to be much better given the shorter timeline. I generally find the MOIC to be the least useful metric. It can be interesting to see how the money will grow, but there are too many important factors that MOIC does not take into account for me to rely on it.

Neither CoC nor MOIC take into account the time value of money. They assume that a payment at the end of the deal is as valuable as a payment today. That isn’t really the case as inflation eats away at the value of money over time, and if you are looking at a long term deal – lasting 10 or more years – that impact can be huge. IRR attempts to address that deficiency by defining the discount rate that makes the net present value of all cash flows equal to 0. In less technical terms, it is the interest rate that makes your initial investment and the current value of all future payments the same. This makes the calculation a lot more complicated [1] (I suggest using the excel formula instead of deriving it from scratch). Because it incorporates all of the payments made to you over the course of the deal and the time value of money, IRR is the most common metric used when promoting an investment.

However, even though it takes into account the time value of money, IRR does not tell you how distributions will be made during the deal. For example, a deal where you invest $100k in year 1 and get back $127.5k in year 6 has roughly the same IRR (~5%) as a deal where you invest $100k in year 1, get back $5k/yr in years 2-5, and $105k in year 6. So if cash flow is important to you, IRR alone isn’t going to be very informative.

There are also two important things to keep in mind when you are comparing different deals, no matter what metrics you are looking at:

• These returns are not guaranteed. This isn’t a bank account or treasury bond, where you should have high confidence in these rates. These are estimated returns based on a number of assumptions. You need to look closely at the assumptions to see if they make sense to you. For example, one common way to increase the projected returns is to assume a lower cap rate on sale than at purchase. That assumption may be valid in certain situations, but certainly not always so you need to understand why the sponsor is making that assumption. If you feel the assumptions are overly optimistic, you may want to rerun the numbers based on scenarios that you are more comfortable with – or just skip the deal altogether.
• These returns do not consider the tax implications of the distributions. This makes sense because the tax that you pay is dependent on your personal circumstances. However, if there are large payments projected in certain years, you should be working with your tax strategist to figure out how to ensure you don’t get an unexpected tax bill cutting into your returns.

After all this, you are probably asking “what is a reasonable rate of return?” That is ultimately something that you need to decide for yourself. Personally, given the tax advantages of REI, if I am looking at a long term, buy and hold, property that will generate consistent 6-10% CoC returns for 20 years with offsetting depreciation, I am pretty happy with that. Alternatively, if I am looking at a shorter term deal, being able to get an MOIC of 1.5x to 2.0x over 5 years works for me as well. Whether that works for you, or you only want deals that return 20% IRR or that have a duration of only 3 years, is based on your investment philosophy.

If you have any questions about this post, please email them to me at blog@mbc-rei.com, I will reply to the questions that are straightforward and will turn the questions requiring more detailed answers into future blog posts.

For additional reading:

[1] https://www.investopedia.com/terms/i/irr.asp

This article is my opinion only, it is not legal, tax, or financial advice. Always do your own research and due diligence. Always consult your lawyer for legal advice, CPA for tax advice, and financial advisor for financial advice.