Investor Basics

Want to know more about cash on cash returns?

Cash on Cash Returns is a very useful indication of how much cash you can expect every year in relation to how much cash you put into the deal. It is calculated by looking at how much cash you will earn after all the expenses of a project have been paid. Cash on Cash is represented as a % of your initial cash investment. Note that Cash on Cash indicates your return before you have paid any tax – any tax that you must pay is not considered in the calculation. (Example: If you invested $100 in cash into a deal, and you receive $10 in returns from the deal each year, the Cash on Cash return will be 10%).

Want to know more about total holdings?

Total Holdings refers to the combined purchase value of your current investments, using the amount of your initial investment in each deal, and any cash in your account or wallet. Total Holdings is unlikely to be an accurate reflection of the actual current value of your real estate investments, as these are likely to have changed since the time you invested. When a deal reaches the end of its cycle, and the Real Estate is sold, and the money returned to you, then that deal will no longer reflect in your total holdings.

Four Categories of Risk & Reward

Core, Core Plus, Value Add and Opportunistic are standard terms to define strategies for investing in real estate based on the risk and return characteristics of an investment. These strategies have led to properties being classified according to which of these strategies they are likely to match. While these categories are mainly used in Commercial Real Estate, the principles apply equally to residential opportunities. 

One of the key aspects of the risk is the predictability and stability of your cash flow from rentals, now and in the future. The more uncertainty around cash flow, the higher the potential risk.  

Using this as a simplification for understanding the four strategies, here is a summary of the categories. 

Core: These properties are fully developed, operating at their maximum potential with little room for adding value through renovations, additions or change. They are in prime locations, with blue chip tenants and constantly fully leased. There is existing rental income that is very stable and predictable, and least likely to be affected in an economic downturn. The value of these properties is tied directly to the existing rental income, and as such any growth in the value only arises when there is a change in the underlying rental market. The returns on these properties is relatively low, as there is strong demand for these low risk investments, and people are prepared to pay higher prices. These properties are generally expensive and owned by larger REIT’s and funds. As the returns are relatively low, there is not a lot of room in the returns to make money after paying off any financing, so these properties usually are not heavily leveraged. 

Core Plus: This property category is similar to Core, though with one or two characteristics that may create a bit more risk or uncertainty around the cash flow. While there is relatively stable and predictable existing rental income, the property may be getting older, or it may be situated slightly further away from the prime metro locations. These aspects introduce an element of risk that the tenant base may be slightly more mobile or not of the same blue-chip quality. Given this increased risk, the price of these properties will be less than for a Core building. This leads to higher possible returns than the Core strategy, though with the additional risk. 

Value Add: As the name suggests, the value-add strategy involves finding properties with existing income from rentals, though where there is also an opportunity to add value to the investment through making changes to the property or tenant base. The changes could be renovating the buildings in order to achieve higher rentals or building new additions to the property. This class of property provides both regular incomes, as well as the possibility of increase future growth in the value through the improvements. However, with any value-add strategy there is increased risk as the changes may cost more than expected, or once the changes are made they do not lead to the expected increase in rental incomes or capital growth. 

Opportunistic: This property category has the highest risk for cash flow and income. Deals generally involve turnaround situations or new developments. There is inherent risk that projections for either the costs of the changes or developments, or the expected income from rentals or the sale of the property after the changes have been made, may be wrong. It often requires bold investors to step in with a high degree of expertise to ensure a successful turnaround.  

Over and above the factors mentioned above, there are many factors that influence risk, and each opportunity will have its own mix and story. The key drivers that lead to a property being categorised into one of the four categories do not capture the complete picture. The property type, Sponsor’s reputation and experience, location, market fundamentals, business plan, and degree of leverage of just some of the factors that an investor should consider. 

What is IRR, ROI and Equity Multiple?

IRR

The Internal Rate of Return is one of the most common indicators for understanding and comparing your returns for real estate investments.

IRR is best explained with an example.

Equity Multiple

First an explanation of Equity Multiple (EM) and average annual Return on Investment (ROI), which are important concepts in their own right, and vital in terms of understanding IRR.

Consider a situation where you invest $1000. After five years you have received a total of $2000 back – $1000 in addition to getting your initial $1000 back.

The equity multiple is a simple calculation of what you get back compared to what you put in. If you receive a total of $2000 back, after putting in $1000, then your Equity Multiple is 2. You received back twice what you put in.

ROI

Your Return on Investment (ROI) is similar, though only takes into account the additional money you made. In the example above, your total ROI is 100% as you made $1000 over and above the $1000 you initially put in.

If we want to express this as an annual average, then we need to divide the total ROI by the number of years. Considering that it took 5 years to get your returns, your average annual ROI is 20%.

IRR

In the above example, WHEN we are paid our money could be important to deciding between two investments. Let’s look at two scenarios from our example above.

1. In the first scenario, you receive your $1000 back in the very first year as well as your first $200, and then $200 a year for the next four years. After five years you have received a total of $2000. Your average annual ROI is 20%.

2. In the second scenario you receive $200 a year over five years, and get the $1000 in the last year. Again, after five years you have received a total of $2000, and your average annual ROI is still 20%.

Though are these two options both equal in terms of your preference as an investor?

In the first year your receive $1200 in scenario 1, while only $200 in scenario 2. For scenario 1 this is great news – firstly the deal now has less risk, as you already have your $1000 back fairly quickly. Secondly you can now use that money again for the next four years to earn more money through other investments or interest.

Scenario 1 is clearly a better option.

The problem with annual average ROI is that it does not take into account WHEN your returns are paid to you. IRR attempts to solve this.

Using the examples above, we can see how IRR can be of value.

The IRR of scenario 1 is 51%, significantly better than the IRR of 20% for scenario 2.

* The definition of IRR requires a complex calculation which we have not included here. For a full description of the IRR equation click here.

What is the real estate value chain?

The value chain of how wealth is created is simple and yet none of us are taught it. There is a reason why 99% of people on this planet will not create wealth and that’s because the top 1% percent are doing things differently. Watch this video to find out what some of the wealthiest people in the world are doing to grow their wealth.