The number one question I get from Passive Investors is, “What is the Best Metric to Use when Looking at an Investment?
It is a fantastic question because there are several metrics that define the health of an investment. So, if you could only pick one, which one would it be and why? Before I share my thoughts, I want to define some of the most common metrics that are used to highlight both the benefits and the drawbacks of each metric.
Cash-on-Cash (CoC) - CoC is the annual cash flow in comparison to your initial investment. In short it takes your total income, both rental income and other income like parking or pet rent, minus all of your expenses inclusive of operational expenses, capital expenses and your mortgage. For example, let’s say you buy a property and you only put in 100,000. If the remaining average annual cash flow for every year you hold the investment is $10,000. Your Cash-on-Cash is 10%. There are a few benefits to using this metric: 1) It is easy to assess the return you will receive on an annual basis if your investment achieves it’s projections and 2) if the investment is achieving its cash-on-cash projections it is most likely achieving the overall business plan. The major drawback is found when your business plan is not based on Cash-on-Cash for example new Development projects or a heavy reposition, sometimes referred to as a value-add). In other words using Cash-on-Cash for these two investment types does not provide any indication on how well the investment is doing.
Average Annual Return (AAR) - AAR is similar to Cash-on-Cash, but it also takes into consideration the profits which are received at sale. In other words, AAR takes the total cash flow and profits and divides it by the hold period. The greatest Benefit is that it is very easy to understand and calculate. The major drawback is that it can be very misleading. As profits tend to be more significant than cash flow, it can dramatically impact the average. This makes this AAR a very difficult metric to use as an ongoing metric for investment performance. it does not tell you when the profits were received and is a tough ongoing metric to use for yearly performance evaluation.
The next metric which is one of the most common metrics that is used is Internal Rate of Return (IRR) - IRR utilizes AAR and the concept of time-value of money. The major Benefit is it can be used to compare investments against each other. The Drawback is it is more complicated to understand/calculate and similar to AAR in the fact that it is a difficult ongoing metric to use for yearly performance evaluation pre-sale.
Multiplier is another common metric people use. Multiplier is used to calculate the multiple your initial investment increased over the life of the hold. For example if you invest 100,000 and receive your initial investment back plus 100,000 in both cash flow and profits you have achieved a 2x multiplier, or you have doubled your investment. The Benefit is it is very easy to understand, however, the drawback: it does not factor in time, nor ongoing performance. For example would you rather invest in a 2x multiple over 2 years versus 5. I don’t know about you, but I would definitely prefer to receive it in just 2 years!
Last, but not least is Profit - Profit is the amount of money earned during the life of the investment. Honestly, I don’t think there is any true benefit to using this metric as a stand alone. And speaking of drawbacks it also doesn’t account for money, nor time invested.
It is clear to see no metric is perfect. Despite that fact, I promised to share my thoughts. If I was looking at an investment mid-hold, I would want to know CoC. The only exception to this is a development project or a heavy value-add with 0 forecasted for CoC. The value I see in using CoC mid-hold is because if the CoC is achieved, most likely the other metrics should be achieved too. The only caveat to that is with respect to proceeds. Proceeds can negatively be impacted if the exit Cap rate was not forecasted correctly, regardless of whether or not the CoC was achieved.
So what’s the takeaway? It’s important to know the definition of metrics and the pros/cons of using each so you can make better investment decisions. Let me know your thoughts in the comments. If you liked this content and you want to see more, make sure to like, subscribe and share!