People love the idea of passive income. The word passive itself implies little to no work, right?
Don’t get me wrong, passive investing requires a whole lot less work than being on the General Partner side (no doubt about that), but successful passive investors aren’t just throwing their money at deal sponsors and then sitting back in the comfort of expected returns.
No, successful passive investors know they have to do two things:
Again, that’s a whole lot less difficult than, you know, actually operating the deal, but it’s also not nothing.
To vet a sponsor or a deal, you have to understand the industry well enough to know whether or not the sponsor and the deal actually make sense.
To that end, you have to know the most common investment return metrics. How, when, and why they’re used.
So, work is required of passive investors, but the good news is it’s not terribly difficult nor time-consuming work. As a bonus, once you know exactly what you’re looking for, you can know almost instantly whether or not you want to jump into a prospective sponsor’s deal.
The fastest way to this nirvana-like place of competence comes with understanding certain key metrics that every deal will hinge upon.
For the sake of this article, we’re going to keep things fairly high level. Just know that we have shot more in-depth videos on each of these metrics (I’ll throw links in as we go in case you want to dive deeper (which you should, because competence breeds confidence)).
Without further adieu, let’s dive into how, why, and when to use certain investment return metrics.
The Investment Return Metrics
The annualized returns relative to the initial amount invested.
This is probably the most common measure investor’s look at. It’s a simple way of quickly identifying how much you’re earning on an annualized basis relative to how much you put into a deal.
If you’re in a deal that pays quarterly distributions that add up to $10,000 by year’s end, and you initially invested $100,000, then your CoC return is 10%.
To contextualize this a bit, over the past 50 years the stock market has returned an average of around 6-7%, so this serves as a bit of a baseline for most investors. The rationale being, why should I invest in this deal with lower returns than I could presumably get on the stock market where the investment is much more liquid.
There’s some issues with this reasoning, but that’s neither-here-nor-there. The important thing to know is that most real estate investors are looking for around an 8% CoC return.
Internal Rate of Return
The total time-adjusted returns of an investment.
IRR is probably the most confusing of the investment return metrics we’re going to discuss. We’re going to keep things high-level, but just know we’ve done a deep dive into the topic here:
Now, from the 30,000-foot view, IRR takes into account how much money you’ve put into a deal at time 0 (aka when the deal starts), which includes distributions, any proceeds from a cash out refinance or sale, and bundles them all together into one macro-return.
From here, the return is then adjusted to account for the time that passed between when you invested the money and when you received those returns.
When you receive the money is an important driver of IRR, because it takes into account the Time Value of Money, which is one of the most important concepts you’ll need to understand as an investor.
Simply put, however, getting $1,000 today is worth more than if you were to receive that same $1,000 a year from now.
Why? Well, two reasons:
- Inflation – $1,000 next year will presumably have less buying power than $1,000 today.
- Usability – Money is only as valuable as what it allows you to do wit h it. Theoretical money is nice, but actual money in hand is always better.
How much more valuable is it to receive $1,000 today than it is next year? Well, that’s exactly what the Internal Rate of Return allows us to quantify.
For us, the Internal Rate of Return is THE most important of all the investment return metrics.
The organic increase of an asset’s value over time.
Alright, this isn’t actually a return metric, but it’s a critical concept to understand none-the-less.
If you own your own home you’re probably somewhat familiar with this concept as you’ve (hopefully) seen the value of that property increase over time. That’s appreciation.
Appreciation is similar conceptually to inflation. That is, over time, resources increase in value while the strength of the money in circulation (typically ever-increasing) slowly weakens.
While it’s important to calculate and project potential appreciation into your underwriting assumptions, it’s critical that your model excessively relies on this mostly uncontrollable factor.
In market’s currently experiencing strong economic and population growth, the rate of appreciation will be significantly higher than in those markets with weak economies and a net-loss to population. These differences don’t just affect the macro, either. Micro-level differences appear on a neighborhood-by-neighborhood basis.
For instance, in St Paul, MN (where Invictus holds the majority of it’s assets), the neighborhood of West Side has seen appreciation close to 10% in the past 12 months, whereas the neighborhood directly bordering it to the east, Battle Creek, has seen only half that growth, coming in at around 5%.
Many factors (beyond the scope of this article) account for these differences, but the important takeaway is this: Don’t bank on appreciation.
If the deal sponsor is projecting the asset will appreciate a certain percentage year-over-year without giving any sort of justification behind that growth (such as historical trends, or knowledge of future development, etc…) then you need to look at their return projections with a critical eye.
We recommend running a sensitivity test to back out the appreciation assumptions, if the numbers still work, fantastic! If not, well… maybe think twice.
Remember, appreciation is only ever realized when some sort of exit event occurs, whether that’s a cash out refinance or a sale, and it’s unlikely any operator, no matter how good they are, can accurately predict the state of the market cycle in a 2-5 year window.
Now, when we say “Don’t bank on appreciation,” this is not to be confused with “forced appreciation”, which is an absolutely different animal altogether and is the backbone to the value-add model of multifamily we execute. More on forced appreciation here: