How to Evaluate Returns in Private Real Estate?

Investing in real estate often appeals to those looking for passive income, yet it requires significant active management and strategic insight. 

The best properties are not the best investments because the ‘value’ is likely already priced in.

Drawing an analogy from the film 'Moneyball,' where baseball team strategies were transformed through detailed analytics, real estate investment similarly benefits from a disciplined, data-driven approach and seeing value where others don’t. 

This guide dives into how to assess property investments effectively from a financial perspective, including all the metrics you should know about.

Evaluating Returns

Many people love the idea of investing in real estate because they think it will produce income without having to do much work.

But unfortunately, that's not true.

General Partners do a ton of work in leading the deal, but Limited Partners also have two very important jobs - vetting the sponsor and vetting the deal.

In the film ‘Moneyball’, a baseball team's success is transformed by Paul DePodesta’s analytical, evidence-based player selections.

Investors can think about properties (and even investing more generally) in the same way.

Good investing is not about picking the best properties; it's about finding good risk-adjusted returns. 

This means it’s about understanding the deeper game—relative pricing, market trends, earning potential, tenant demands, and the like. 

Often, the best stuff is the most expensive, and there is little return there. Check out Yura Capital’s article on Choosing Your Real Estate Investment Strategy to learn more about that.

So how do you evaluate a deal with a numbers-driven approach?

Just like in 'Moneyball', success in real estate isn't just about the obvious choices; it's about understanding the full scope of the game. 

Here are the key metrics you should know:

Internal Rate of Return 

The internal rate of return (or IRR) is a widely used number across all parts of finance—private, venture capital, and commercial real estate. 

To understand an IRR, first we need to understand a Net Present Value (NPV) calculation.

Net Present Value (NPV) is used to assess the profitability of an investment, taking into account the time value of money.

The time value of money is different for different investors because it's based on their opportunity cost of that money.

One investor might be happy with a 5% return; another investor might want 20%.

This is called the discount rate.

Once we have a discount rate, the Net Present Value (NPV) calculates the difference between the present value (PV) of cash inflows and the present value of cash outflows over a period of time.

Let's bring this to life with an example.

Let's say we use a 10% discount rate; this means $100 that we receive 12 months from now is only worth $90. And $100 that we receive 24 months from now is only worth $82.

So the present value (PV) of those two cash flows is $172 ($90 + $82)

Let's say I offered to give you $200 today, and then I got the cash flows.

Your net present value (NPV) assuming a 10% discount rate would be $28 ($200 less $172).

Now back to the IRR calculation.

This is a closely related concept and simply finds what the discount rate is to get that NPV to $0.

In this example, if we use a 22% discount rate, the NPV goes to $0. 

What this means is that if we take them and discount them by 22% per year, the present value is $0.

IRR measures the annualised rate of return over the investment horizon. 

In real estate, this includes the cash outlay up front, the operating cash flows of the asset, and the eventual sale proceeds of the property.

To calculate IRR, there is the formula you use in Excel, and it basically guesses the different interest rates that cause the net present value of all those three things to equal zero. The investment, the cash flows, and the terminal value.

Now it's important to know that this has nothing to do with the risk profile, so if you take on more risk, you should be compensated with a higher IRR.

This comes back to that discount rate we spoke about earlier. 

So what is a good IRR? 

It depends on the investment, but in the real estate industry, the target IRR on a property investment tends to be around 12% to 18%.

Core deals have the lowest expected return and risk, while opportunistic deals that commonly include stuff like new developments carry the highest risk and expected return profile.

This is really important to understand because you can always chase higher IRRs by taking on more risk in the business plan or the capital structure.

Something that newer investors often get wrong is chasing the highest IRR deals (e.g., 20%), thinking that if the plan underperforms, they will still end up with a great IRR (e.g., 18%).

But the thing is that the IRR of those high-risk deals doesn't go down a few points; it might actually go to zero as the equity is completely wiped out. Hence, experienced investors will be much happier with a safe 12% versus a risky 18%.

In summary, here are the advantages and disadvantages of the IRR calculation.

Advantages

• It recognises the time value of money
• It's pretty simple once you understand how it works

Disadvantages

• The economies of scale ignored: a 15% IRR on $50 million is way better than a 20% IRR on $1 million 
• It can be impractical sometimes as it carries an implicit reinvestment Rate 
• It doesn’t take into account risk

Equity Multiple

An equity multiple is a much simpler calculation and better used to understand the scale of the return.

The Equity Multiple of an investment is a ratio of total cash returned over the life of the investment to total cash that was outlayed.

If I bought those two cash flows of $100 from our earlier example for $100, it would mean that I put in $100 and got back $200; my equity multiple is 2x.

The equity multiple is helpful to evaluate investment opportunities with longer hold periods. 

The key advantages of using an Equity Multiple are that it's an easier equation to understand than IRR and is quite popular in the real estate world. 

It doesn’t discount the present value and doesn’t take risk or other variables into account, so it shouldn’t be looked at in isolation.

This is also the main disadvantage - doubling your money in three years is way better than doubling your money in 10 years, but both investments would give you a 2x multiple.

So whenever you’re looking at an equity multiple, it's critical to know over what time period?

So is the IRR or equity multiple more important? You need to look at both to understand what's going on.

Cash on Cash

Now the Cash on Cash return tells you the annual return on the money that you have invested in the real estate deal.

Unlike other real estate investing metrics, it includes debt service, which can make it hard to compare across different properties.

The Cash on Cash return takes the annual pre-tax cash flow of the property, divided by the equity invested.

To get the cash on cash return, you take the net cash flow after debt service and divide it by your total equity investment in the deal. 

Cash on Cash returns can be used to compare cash returns between properties in different real estate markets. This is unlike the more common cap rate formula, which should only be used to compare similar properties in the same market. 

Different investors value different things, and you can find properties that generate 10% cash flow, but you’re likely making the trade off in quality. 

Eventually you’ll have repairs on maintenance that will wipe out your cash flow, or when you go to sell, you won't get the value you want.

Here are the advantages and disadvantages of Cash on Cash returns.

Advantages

• Easy to Use 
• You can focus on one thing: cash flow 
• It's simple to adjust for vacancy, opex, and financing 

Disadvantages

• Does not account for other risks with the property
• Minimises the appeal of high-quality real estate

Cap Rates

A cap rate is the most common evaluation metric in real estate and probably something you've heard of before.

It measures the rate of return based on the Net Operating Income (or NOI) divided by the property value.

Cap rates essentially provide a snapshot of a property's yield in a specific year without factoring in future income increases or financing costs. 

It is the most common market benchmark for valuing commercial real estate and is a fundamental tool for investors to compare the value and return potential across different real estate investments. 

Understanding what a ‘good deal’ or ‘bad deal’ is in real estate requires an understanding of the context in which it is being asked.

By a good deal, that generally means—will this property generate attractive, risk-adjusted returns compared to other investment opportunities?

What this means is that two seemingly identical buildings built at the same time by the same developer will have different valuations. 

For example, while their locations may be almost the same, their tenant profiles, rent performance, and expense management could lead to wide variances in value. This can make it difficult to do side-by-side comparisons of properties, but you still always need to account for these differences.

Cap rates and property values have an inverse relationship. Higher cap rates generally equate to lower values, and vice versa.

This is really important to understand. 

Even a slight cap rate movement, say from 3% to 4%, is more impactful than it appears, equating to a 33% change in property price. 

When leveraged with debt, such as a typical 50% loan-to-value ratio, this fluctuation can significantly alter the equity value. 

Let's look at an example with some numbers: if we take a commercial real estate investment with a Net Operating Income of $1m, we can see the difference in valuation by applying different cap rates.

At a 4% cap rate, the building is valued at $25,000,000

At a 6% cap rate, the building is valued at $17,000,000

At an 8% cap rate, the building is valued at $12,000,000

The key takeaway here is to always pay close attention to cap rate trends; they're a powerful indicator of market sentiment and property value.

Here are the advantages and disadvantages of using cap rates.

Advantages

• Most common metric used by real estate investors, agents, appraisers, and even banks
• Cap rates can be easily compared across investments

Disadvantages

• It’s difficult to determine an accurate future-looking number and involves lots of assumptions
• A cap rate only measures a snapshot of a deal, not the life cycle of an investment

Yield to Cost

In evaluating value-add real estate investments, a key metric that investors should pay attention to is the 'Yield to Cost'.

Calculated by taking the Stabilised Yield, which is:

• Current cash flow yield (i.e., the in-place cash-on-cash return)
• Plus the upside yield from the value-add strategy (i.e., the improvements)

Then divide the ‘Stabilised Yield’ by the sum of the acquisition price and the capital investment.

This equation essentially represents an investment's potential return, factoring in the current state of the property and the capital expenditure improvements needed to enhance its future earning potential.

By factoring in the upside yield, which represents the potential increase in income after improvements, Yield to Cost provides a more accurate estimation of the return on the capital spent on both acquisitions and improvements.

Example

Property Overview

• Purchase Price: $1,000,000
• Current NOI: $50,000 per year
• Current Cash Flow Yield: 5%
• Calculation: $50,000 NOI / $1,000,000 Purchase Price

Capital Improvement Plan

• Investment: $200,000
• Projected Increase in NOI: To $100,000 per year

Yield to Cost Analysis

• Upside Yield: 8.3%
• Calculation: $100,000 Increased NOI / ($1,000,000 + $200,000 Total Investment)

Financial Impact of Improvements

• Additional NOI: $50,000 (from $50,000 to $100,000)
• Value-add Return on Improvement: 25%
• Calculation: $50,000 Additional NOI / $200,000 Improvement Cost

The planned $200,000 capital improvements are predicted to double the NOI and significantly enhance the property's yield from 5.0% to 8.3%, reflecting a 25% return on the additional investment.

The beauty of the Yield to Cost metric is that it captures a lot of the moving pieces in a value-add real estate investment.

It provides a more comprehensive picture of the potential return on investment than relying solely on the capitalisation rate, which doesn't account for improvements that can boost a property's income-generating potential.

This is why often value-add investments can trade at lower capitalisation rates, as buyers know that the yield of the asset can be improved through a value-add strategy.

Lastly, one aspect that the Yield to Cost fails to consider is the timeline, as it does not account for how long it takes to achieve the projected yield.

This can be a significant oversight, as the time to get to the Yield to Cost might be longer than anticipated, which could affect the overall return on investment.

Delays in renovations, permit approval, or tenant turnovers can prolong the timeline, which then affects the investment’s ultimate profitability.

Investor beware

Numbers are super important and ultimately are the best decision factor when evaluating investments, but the number one thing when investing in properties is getting the General Partner.

The allure of good luck numbers—be it Internal Rate of Return, Equity Multiples, or Cap Rates—should not distract from the paramount importance of due diligence and the reliability of investment partners, especially when investing in property syndicates.

Because the thing is, financial projections can be made to tell almost any story you want based on assumptions, as they say, garbage in, garbage out.

Deals can be easily manipulated to show whatever type of projection a General Partner wants to see. This is why it's so important to invest with people that you know, like, and trust.

Conclusion

Effective real estate is not just selecting promising properties. It demands a rigorous evaluation of financial metrics and a keen understanding of market dynamics.

By analysing key indicators such as Internal Rate of return, Net Present Value, and cap rates, investors can strategically navigate the complexities of the real estate market.

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