When considering an investment in commercial real estate, it is important to understand what you may get in return. The yield is the annual return you are expecting to receive on your investment. It is crucial to combine several financial tools to get a more accurate picture of the annual return over time. For example, the equity multiple is useful as a quick evaluation tool. However, it is more helpful when combined with the internal rate of return (IRR) because equity multiple doesn’t take into account that capital accrues over time. Investment yield will also depend on many variables present in the larger economy, such as interest rates and the existence of inflation. For example, you can research some of the effects of the COVID-19 pandemic on the commercial real estate market.
Start learning how to calculate yield on an investment property by reading about these metrics: internal rate of return, cash on cash return, and equity multiple.
What is IRR? What Does it Have to do With Investment Yield?
IRR is a common tool used to evaluate investment performance. It is the annualized rate of earnings on an investment. One general rule an investor might follow is that the higher the IRR, the higher the return. The lower the IRR, the lower the risk. However, that is not always true.
IRR is typically expressed as a range of percentages, e.g., 8% – 12%. It represents the interest rate that makes the market value and total cost equal. In order to calculate IRR, you need to understand the net present value (NPV) of the possible investment.
IRR = The interest rate that makes the NPV equal to zero
This formula accounts for cash distributions over a projected period. It is important to factor in time and projected hold periods when calculating investment yields. Learn more about how to calculate NPV and IRR.
What is Cash on Cash Return? How Can it be Used to Calculate Yield?
Cash on cash return is used when acquiring a property to understand the current and future income profitability of an investor’s initial invested capital. It is the ratio between annual operational net cash flow and the total amount of cash (equity) invested in the deal.
Cash Flow / Invested Cash = Cash on Cash Return
This is a good financial metric for investors to use when they want to make a comparison between an equity real estate investment to other types of income producing investments, such as bonds or preferred equity investments. Learn more about cash on cash return, and when to use it.
What is Equity Multiple?
Equity multiple, also known as the realization multiple, is a simple formula:
Equity Multiple = Cumulative Distributed Investment Returns / Paid-in Capital
While equity multiple is a great metric to evaluate a commercial real estate deal, it is best used with other deal metrics like IRR. This is because it does not account for the time it takes to distribute returns. Internal rate of return provides a better overall picture of the distribution cycle. Take a look at our article on how to evaluate investment returns with equity multiple.
Many Metrics, One Investment Yield
Equity multiple, cash on cash return, and internal rate of return are just a few of the metrics used to calculate investment yield on a commercial real estate property. In order to create a successful investment in commercial real estate, the best route is to thoroughly evaluate the property. Use several metrics together to understand how the investment property is likely to perform over time. Moreover, one should always partner with a reputable real estate sponsor with experience in the field. Learn more about commercial real estate investing through the Library of Congress’ Real Estate Resource Guide.