5 Measures of Return in Apartment Syndications
If you’ve ever looked at investing in apartments through a syndication, you’ve likely seen the terms cash on cash return, internal rate of return, average annual return, preferred return, and equity multiple. While these are all a measure of return, they are all unique and we’ll break them down here.
Cash on Cash Return (CoC return) – a calculation that refers to the return on invested capital, or the cash income on the investment. If you invested $100,000 and the investment returned $8,000 to you in one year, your cash on cash return is 8%. This simple equation is determined by taking the annual dollar income return divided by total amount of investment.
Internal Rate of Return – The rate of return that makes the net present value of all cash flow equal to zero. This one is sometimes the most difficult to explain but a more sophisticated measure of return. The higher the projects IRR the more desirable it is to undertake the project. The IRR is often a good investor metric to compare similar projects with different or varying pay out streams. Investors that get more money early in the life cycle will have a higher IRR than one that pays off only with a sale in say 5 years.
Average Annual Return – An annualized total return is the average amount of money earned by an investment each year over a given period. It is calculated as a geometric average to show what an investor would earn over a set time period if the annual return was compounded. Here’s an example: The investment earned $34,375 over 4 years. Divide that number by the 4 years equals $8,594 as an average annual return. Divide $8,594 by the initial investment amount of $100,000 to calculate the average rate of return of 8.59%. In value-add syndication, the average annual return may be deceiving (higher) than the IRR (Internal Rate of Return) as a large part of the investor returns come in the year of sale (modeled as year 5). IRR typically would be a better measure for varying cash flows over a set time horizon. Think about the time value of money. Would you rather have $1 today, or $1 in say 5 years?
Preferred Return – (not a guarantee) but the next best thing for investors. The preferred return or “pref” is a return to a limited partner in an investment syndication that is paid first before the general partner gets paid their share of distributions or profits at sale. Typical preferred returns on apartments are right around 8%. Preferred returns should be cumulative and accrue to investors each year if the investment falls short of the target. Deals are usually structured to have this be an annual target for the investment hold period. So, an 8% preferred return over a 5-year hold period would mean investors are targeted to be paid up to 8% each year over that time span. If the investment earns 6% in one year, then the following year the new pref target is 10% (8% target plus 2% catch up from prior year) and so on until the investor is caught up. That is cumulative and accrues to investor and should be paid before general partners get their split on the cash flow or capital events like refinances or sales. That is why we think its so important for investors to see this in the deal, it’s an alignment of interests with the investor being put first.
Equity Multiple - This is a popular and easy metric to understand. If I invest $100,000 and it grows to $200,000 (including distributions and sale profits) then it’s a 2x (double my investment). If it grows to $185,000, then it’s a 1.85x. The higher the multiple, the better the return. Most of the deals we review are for a typical 5 year hold period and target a 2x multiple.
There are many more common financial metrics and key terms you want to understand before investing in a syndication, but these are the top 5 terms when it comes to discussing expected returns and the differences between them.