The Most Important Real Estate Return Metrics [& How To Use Each]

There are a lot of ways to measure performance in commercial real estate, but there are a few numbers that are considered by far to be the most important.

These are the metrics that are used by investors to come up with property valuations, market deals to raise capital, and calculate cash flow splits between partners within an equity waterfall.

So in this post, we’ll walk through three of the most important return metrics in commercial real estate, how (and why) each of these is used, and which of these you might want to focus on most when analyzing a deal.

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Metric #1: The Cash-on-Cash Return

The first metric I want to highlight in this post is the cash-on-cash return.

This cash-on-cash return is calculated by taking the cash flow from operations distributed to investors each year and dividing that by the equity invested in the project up to that point.

And what makes the cash-on-cash return unique is that this metric is measured on a year-by-year basis and only incorporates cash flow from operations within the numerator of this formula, which makes this a lot less speculative than many other return metrics.

Most performance figures that real estate investors use (including the other metrics we’ll talk through later in this post) include an estimated sale value within the projected cash flows, which can make these heavily reliant on changes to capital market conditions.

But the reality is that property values can be extremely volatile over time, and major swings in interest rates or investor demand for real estate can have significant impacts on what a property would sell for.

Because of this, the cash-on-cash return is considered one of the most reliable metrics for investors who consider themselves somewhat risk-averse and who prioritize a level of certainty when investing in commercial real estate.

In most cases, the cash-on-cash return is also the most relevant metric for investors looking to supplement or replace their income with cash flow from real estate, since this is the return metric that directly shows what the annual income stream from an investment is projected to be.

For example, if an investor contributes $100,000 into a deal with a year 1 projected cash-on-cash return of 7%, that investor would expect to receive $7,000 in distributions in that first year of ownership.

It goes without saying that these distributions aren’t guaranteed, and these can be subject to change if rents were to decrease, operating expenses were to increase, or debt service were to increase due to a floating interest rate. However, for investors looking to get more clarity on the income they could generate for every dollar they invest, the cash-on-cash return is extremely important.

Metric #2: Equity Multiple

The next metric I want to highlight gives investors a more long-term view of the projected performance of a deal, and this is the equity multiple.

The equity multiple is calculated by taking the sum of all cash flow distributions to investors and dividing this by the sum of all cash flow contributions from investors throughout the entire life of the investment.

For example, if an investor contributed $100,000 into a deal, earned $7,000 per year over a 5-year period in distributions from ordinary operating cash flow, and the property was sold at the end of that 5-year period with net sale proceeds to the investor of $150,000, this would represent a 1.85x equity multiple on that initial contribution.

Because of how simple this figure is, this can be a really helpful metric to understand what an investor’s projected profit would be on a deal in relation to their original equity investment, and whether that profit would ultimately be worthwhile based on the risk the investor would be taking.

With that said, one thing to note about the equity multiple is that this will inherently be higher the longer the property is projected to be held, since the numerator of this calculation factors in all cash flows generated throughout the life of the deal. But even though that’s the case, this metric is still a really helpful benchmark for investors who want to understand their total projected distributions as a multiple of the cash they contribute.

Metric #3: Internal Rate of Return (IRR)

The final metric I want to highlight here is widely considered to be one of the most important return metrics within an investment analysis, and this is the internal rate of return (IRR).

The IRR measures the annualized, time-weighted return on capital invested, taking into account both the timing and amounts of each cash flow, and this is often considered the gold standard in commercial real estate for measuring investment returns.

Just like the equity multiple, the IRR factors in both cash flow from operations and cash flow from sale proceeds, but instead of measuring a multiple of invested capital, the IRR uses a percentage figure to measure investment performance.

This makes this metric a really helpful benchmark for investors looking to compare the projected performance of a real estate deal to other investment vehicles, like publicly traded stocks or private equity investments. And because of this, most institutional investors will advertise their funds with specific IRR targets when raising equity capital.

Target IRR values will often directly dictate how real estate investment firms value properties in the market, with their maximum offer prices on deals typically being based on a purchase price that would allow them to hit these figures.

Now, a downfall of the IRR calculation is that because this metric is so heavily reliant on the timing of each cash flow, the IRR can sometimes be significantly higher with projected short-term hold periods, even if the deal is significantly less profitable than it would have been with a longer-term investment horizon.

This is a big reason why the equity multiple is very heavily scrutinized by private equity firms and major capital allocators who invest as limited partners, since a high IRR isn’t necessarily always indicative of maximizing total profit.

How To Learn More

If you want to learn more about these figures, or how to integrate these and other CRE investment metrics into a real estate financial model, make sure to check out our all-in-one membership training platform, Break Into CRE Academy.

A membership to the Academy will give you instant access to over 120 hours of video training on real estate financial modeling and analysis, you’ll get access to hundreds of practice Excel interview exam questions, sample acquisition case studies, and you’ll also get access to the Break Into CRE Analyst Certification Exam, which covers topics like real estate pro forma and development modeling, commercial real estate lease modeling, equity waterfall modeling, and many other real estate financial analysis concepts that will help you prove to employers that you have what it takes to tackle the responsibilities of an analyst or associate at a top real estate firm.