Cash on Cash Return vs IRR: Understanding the Difference

For commercial real estate investors, having access to as many metrics as possible to provide insight and comparison opportunities is critical. Various metrics are available, including cash-on-cash return and internal rate of return, enabling investors to compare properties more closely when deciding which to choose for investment.

Most investors set their own threshold of what is acceptable to meet their needs or to ensure they hit a certain target before investment. Yet, when investors consider dozens of opportunities each day, it is helpful to have a straightforward metric to help compare properties. These two figures are core components, and knowing the difference between IRR and cash on cash is critical.

What Is Cash on Cash Return (CoC Return)?

The cash-on-cash multiple is a type of rate of return ratio. It provides insight into the total cash earned for a property over the total cash invested into the property. It is based on cash flow before tax within a specific period divided by the equity that’s invested at the end of that period.

Cash on cash return (CoC) is a levered metric or an after-debt metric. By comparison, an unlevered metric is “free and clear” returns. Investors use this metric as a way to assess an investment opportunity.

Cash on Cash Return Formula

The formula for cash on cash return is rather simple:

Annual Net Cash Flow divided by Invested Equity equals Cash on Cash Return
In most cases, this is expressed as a percentage. When it comes to the cash-on-cash calculation, real estate investors typically look at their investment return.

How to Calculate Cash on Cash Return

Applying the formula above, here is an example of how the cash-on-cash works (you can also use a cash-on-cash calculator to help you with this process.)

Bob wants to purchase a multitenant property for $1 million. He puts in $250,000 in equity in the deal. He then finances the $750,000. In this example, the equity investment is $250,000. (Now, this does not include things like closing costs which would also be factored into the equity if paid out of pocket).

After a year, the property provides an annual rental revenue of $120,000. Mortgage payments on the property total $55,000. In addition, Bob invests another $20,000 into the property improvements.

To determine the cash on cash return, the first step is to determine the annual net cash flow for the property. In this situation, the annual cash flow for the property follows this formula:

• Total Gross Revenue minus Total Expenses

In our example, the annual cash flow is $120,000 minus $75,000 or $45,000.

Next, to get the Cash on Cash Return, we need to divide the annual net cash flow by the amount of equity put into the property, in this case, $250,000.

The equation is $45,000 divided by $250,000 equals 18%.

This figure means that the total cash on cash return for that property is 18%. That also means that the investment’s profit for the year will be 18% of the amount of cash that is invested initially.

What Is a Good Cash-on-Cash Return?

Investors typically need to seek out their own answer to this since it is very much dependent on what their needs are and preferences goals are. For some investors, earning 8 to 10% cash on cash return is enough for them. Others do not consider options under 20% cash on cash yield.

Limitations of Cash on Cash Return

There is no doubt that cash on cash return is an important factor to consider, but it has some limitations. For example, it is a simple calculation that measures investment performance. Use it as a starting point when considering investment properties, and then dig deeper into other metrics for more insight. CoC often does not consider things like the length of investment of operating cash flows within a holding period or the reversion cash flow that comes from the sale of the property later.

What Is IRR (Internal Rate of Return)?

Another key figure is the IRR formula. Understanding IRR in real estate can provide more opportunities for you to see the difference in these funding methods. Cash on cash does not account for what investors call the time value of money, but this is where IRR comes into play.

Internal rate of return (IRR) is the interest rate that makes the net present value of all of the property’s cash flow zero. Another way to look at it is the actual annual growth rate calculated by isolating compounding interest’s effects in situations where the investment is more than a year.

Internal Rate of Return Formula

The formula for this metric is complicated and typically not done by hand. Rather, it’s best to utilize Excel or another program for calculating it.

The formula for Calculating IRR

Here is what the formula looks like:

In this,



Ct=Net cash inflow during the period

C0=Total initial investment costs

IRR=The internal rate of return

t=The number of time periods

You can learn more about setting up Excel to calculate this by visiting this link.

What Is a Good Internal Rate of Return?

What is a good IRR? Again, that’s subjective and really depends on the investor’s goals and needs. Most of the time, a 5-year IRR should be around 15% or higher, and sometimes it can be much higher than this.

Limitations of IRR

IRR aims to provide insight into the total return on investment by incorporating compounding interest into the process. However, when IRR is high, that does not always mean that the investment is seeing a cash flow at the current time. That is because this metric also uses the final sale or the existing assets as a component of the formula. That makes it impossible to be the only factor considered during this process.

What’s the Difference Between IRR and Cash on Cash Return?

IRR is the total interest earned on the money the investor puts into the project. The difference between this and CoC is that IRR is focused on the total income earned throughout the investor's complete ownership of the property, whereas CoC provides an annual segment view of the property.

Cash on Cash Return vs. IRR: Which One Should You Use?

IRR is much harder to calculate and typically requires having a significant amount of data about the property at the time of estimating. However, it is worth using both metrics. Often CoC is the first step to weed out less-than-desirable properties. Then, before investment, investors take a closer look at these metrics to provide a more comprehensive review of the investment’s opportunities.

Wrapping Up

What is a good cash-on-cash return? When should you use IRR? These are very important questions.

The key here is that commercial real estate investors should have as many metrics as possible available to them to use to determine which property could be ideal and which meets their very specific needs or goals. It’s not often a question about which one to use but how a property looks using both of these metrics.

 

Source: Cash on Cash Return vs IRR: Understanding the Difference

https://www.creconsult.net/market-trends/cash-on-cash-return-vs-irr-understanding-the-difference/

Chicago Renters Only Make 69% Of The Income Needed To Afford Starter Homes.

The average income of renters in Chicago isn’t quite enough to allow them to afford an entry-level home. And as long as interest rates stay high and inventory is low, that will likely remain the case.

As of October, when interest rates were 7%, the average household income needed to cover a mortgage for a Chicago starter home was $63.4K. But the average income of renters was $43.6K, according to Point2Homes research.

That means Chicago renters make only 69% of the income needed to become first-time homeowners, according to Axios reporting on the study.

Point2Homes data indicates the average cost of a Chicago starter home is $204.7K, effectively pricing out many renters given rising interest rates and shrinking single-family housing stock.

Only 15 of the 50 largest U.S. cities offered average starter homes for less than $200K, the traditional affordability cutoff for first-time homeowners.

Rising mortgage interest rates, high housing prices, and limited inventory make it harder for people to buy their first homes. According to the report, "the modest, bare-bones homes of yesteryear have become the stuff of myths and legends."

About 70% of all new builds were starter homes in the 1940s and 40% in the 1980s, but the percentage had fallen to 7% by 2019, according to Census Bureau figures.

"Renters’ homeownership dreams don’t match the reality in almost any of the large U.S. housing markets," the report's authors said.

Earlier this year, Business Insider reported that first-time home homeowners struggled to afford the typical 20% down payment on a home, which averaged $78.4K based on median home prices when the article was published in March.

 

 

Source: Chicago Renters Only Make 69% Of The Income Needed To Afford Starter Homes

https://www.creconsult.net/market-trends/chicago-renters-only-make-69-of-the-income-needed-to-afford-starter-homes/

2023 eXp Commercial Commercial Real Estate Symposium

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The Commercial Real Estate Symposium will provide junior and senior agents and brokers with valuable insights on topics, including: international opportunities, capital and funding for small businesses in today’s market, how to attract investors, and much more.

Dates: April 25-26, 2023
Start Time: 9 a.m. - 4 p.m. CST
Location: eXp Commercial Campus

We look forward to seeing you in the metaverse!

Important: Please download the virtual eXp Commercial Campus prior to the event, and follow the instructions to login and create your avatar. Feel free to explore the campus before the event begins.

 

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https://www.creconsult.net/market-trends/2023-exp-commercial-commercial-real-estate-symposium/

Here’s What to Expect in Investment Sales in 2023

Before we welcome 2023, let’s look at 2022 and how the New York City investment sales market performed, where we are now, and where we might be headed in the new year.

Can you believe that the 10-year Treasury one year ago was 1.48 percent? Doesn’t it seem like that was years ago? I think the thing that 2022 will be most remembered for will be inflation, the unprecedented pace of interest rate increases, and the impact these factors had on the commercial real estate lending markets. To say that things are more challenging today is an understatement.

Coming into 2022, we were very optimistic. In the fourth quarter of 2021 in Manhattan, the sales market for properties over $10 million saw $8.5 billion of volume and 89 sales, both quarterly highs going back to 2016 (except the $9.2 billion total in the second quarter of 2019). Interest rates were low, metrics were moving in the right direction, and it seemed like we would be pulling out of an investment sales malaise that began in October of 2015. 

 

For perspective, in 2015, during the cyclical peak, there were $57.5 billion in sales over 484 transactions. The trough was in 2020, with $11.1 billion in sales over 104 transactions. In 2021, those numbers increased to $15.75 billion and 191 transactions. Through the first three quarters of this year, we were on pace for $21.7 billion and 215 transactions, increases over last year of 38 percent and 12 percent, respectively. However, given how increased interest rates have impacted the market, we expect fourth-quarter 2022 results to be well below the yearly trend. The optimism we went into 2022 with is absent from our perspective heading into 2023.

Inflation was tremendous in 2022, but is that a surprise to anyone? How could inflation not be impacted if the federal government pumps trillions of dollars into the economy? Notwithstanding how much you think the war in Ukraine has impacted things, inflation would still be elevated even if the war never happened. Reducing our ability to produce energy and pumping unprecedented amounts of capital into the economy was a cocktail that could result in only one outcome.

At the same time, many economists believe that the Fed has misdiagnosed the labor market. It scared some folks when the Fed announced that interest rates would “continue to increase until the labor market cools.” However, if we look at the number of jobs in the U.S. economy, there are only about 1.2 million more jobs today than there were in 2019. If we had projected where we would be at the end of 2022 back in 2019, expectations would have been that we would have 3 million to 4 million more jobs by now. The labor market is not overheated; it is undersupplied. This is evidenced by the reductions we have seen in the labor participation rate, which is tangibly lower than it was pre-pandemic. Some economists believe we are being treated for a disease we don’t have. So interest rates have risen, and, importantly, they have risen at an unprecedented rate.

In November, the Fed increased interest rates by 75 basis points, the fourth consecutive 75-basis-point increase, after a 50-basis-point increase in March. This unprecedented pace of rate increases was three times faster than the increases we saw during the period from 2004 to 2006. This pace, inexplicably, doesn’t consider that Fed action normally has a many-month lag before the economy is impacted.

For the commercial real estate market, the impact of these increases was not felt until about three months ago. At that point, the commercial mortgage market was tangibly impacted, and borrowing became much more expensive for borrowers. Interestingly, because of this, comparable sales are only starting to become valid for determining value today. Up to now, most closings are occurring based on contracts signed in the old market and do not consider the current financing market. To determine a value today, we rely much more on contract negotiation activity than transactions that have closed.

Current market conditions have highlighted the fact that cap and interest rates are not highly correlated. Most folks believe this is the case, but it is not. Interest rate fluctuations generally predict the direction of cap rates but not the magnitude of those increases. The cap rate versus interest rate relationship over the long term shows that the relationship is not highly correlated. The flow and availability of capital are more impactful on cap rates and more highly correlated over time rather than increases in interest rates. And that flow and availability of capital are most highly correlated to an age-old battle. Markets are a constant battle between fear and greed, and today fear is winning — so cap rates are rising.

As we head into 2023, refinancing risk will be the most-watched market dynamic. Unlike in 2008 and 2009, regulators won’t allow lenders to extend and pretend. So an owner with a $35 million loan on a $50 million asset will be faced with a big decision when the mortgage matures, and the refinancing proceeds available will be $27 million. The first question is, does the owner have the $7 million to put into the property to effectuate the refinancing? If the answer is no, the owner is left with a decision of whether to sell all of or a partial interest in, the property. If they have the money, will they “invest” that fresh capital into the asset? These will be profound decisions for folks with debt maturing.

Concerning product type performance, each sector will have its own drivers of activity, and there are currently more questions than answers. How will return to work play out in the office sector as leverage in the labor market shifts? How will aggregate demand be impacted as flexible working environments ebb and flow? How will consumption patterns impact the demand for space in the industrial market? Within the multifamily sector, will our elected officials change policy to promote the creation of more supply? In the land sales market, will policy impact property values such that owners are incentivized to sell? In the hotel market, we have seen a tangible reduction in the stock as many rooms have been converted to alternative uses. How will market conditions impact travel patterns? And how will the strength of the dollar impact decisions about where people go and for how long?

From a more macro perspective, will rates continue to rise, and if so, how much? Inflation, although still elevated, seems to be slowing. Sectors of the economy such as housing, construction, and manufacturing are also slowing. However, services are still seeing upward pressure on prices. So will the Fed continue to raise rates, or will it pause to let the lag kick in? And will the present yield curve inversion lead to a recession? In 14 of the last 15 times, the yield curve has inverted, and a recession has followed.

Notwithstanding these questions, one thing is certain: If you ask investors when they made the best deals of their careers, you will universally hear that they were made at times like we are in right now and are likely to see as we head into 2023. Investing in real estate takes capital and, most importantly, guts. Which investors will have the intestinal fortitude to dive in when many take a wait-and-see position? Will today's deals be the ones investors look back on fondly, years from now, when they all wish, “If I had only bought more!”

Clearly, there is an uncertainty going into 2023 — at a level we haven’t seen. Rest assured that we will continue to track all of the indicators that will provide insight into how trends will unfold and will continue to share those insights with you on these pages.

Meanwhile, best wishes for a safe, happy and healthy holiday season and a prosperous New Year!

 

Source: Here’s What to Expect in Investment Sales in 2023

https://www.creconsult.net/market-trends/heres-what-to-expect-in-investment-sales-in-2023/

The Dangers of Selling Commercial Property Too Late

The last downturn

cost those who chose to sell commercial property an average of

30.3% of their property value

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Reason #1

Why people sell commercial property too late:

Complacency

 

Complacency is the most dangerous state to ignore.

It’s the moment before the market corrects and values decline. When the market goes through this initial correction, our natural tendency is to be complacent because initial corrections actually look like a cool-off period.

Then we expect the market to pick up again and continue with its growth phase.

But, the market continues to deteriorate and worries creep in as we wonder what is going on. Next, it is normal to say to yourself that your investments are good ones that they’ll ultimately come back.

When the market continues to soften until it seems there is no hope in coming back, that’s the absolute bottom of the market and the worst time to sell.

 

This point of capitulation is one of surrender and of asking how the government could let something like this happen.

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Reason #2

Why people sell commercial property too late:

Ownership and Identity

 

In order to avoid loss, people will overvalue what they own.

That is what Richard Taylor, Daniel Kahneman, and Jack L. Knetsch identified with the Endowment Effect. In fact, Kahneman and Knetsch won the Nobel Peace Prize for their research in this area of behavioral economics.

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It’s normal for people to overvalue what they own.

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In a study with Cornell undergrads, broken into groups and given identical coffee cups, Kahneman and Knetsch told one group to value the cups they owned and the other group to value the cups they would purchase.

They found the undergrads with the coffee cups were unwilling to sell their coffee cups for less than $5.25 while their less fortunate peers were unwilling to pay more than $2.25 to $2.75.

But, it was Carey Morewedge’s research into the Endowment Effect that revealed that it’s not loss aversion that leads to overvaluation, it’s ownership and identity.

Morewedge found that it’s our sense of possession that creates the feeling of an object being mine, which then becomes a part of our identity.

 

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Reason #3

Why people sell commercial property too late:

Loss Aversion

 

Why is it so difficult to sell commercial property in a market decline?

According to Brafman and Brafman, authors of Sway: The Irresistible Pull of Irrational Behavior people will go to great lengths to avoid perceived losses.

What’s more, people also succumb to their will to recover what once was.  They will spend whatever it takes not to lose, be it time, money, or emotional resources.

Imagine watching someone playing craps in Las Vegas. When they are on a roll, taking in their winnings, they race through the growth phase, reaching the peak of the game.

They feel ecstatic.

But what happens when the tide turns and they start to lose?

They enter the complacency stage, call it a short turn of bad luck, and keep playing.  They believe they will return to the top. But their bad luck continues.

By waiting to avoid losses, people hold off and then sell at the wrong time — maximizing their losses.

 

They lose their winnings, keep playing and generate losses. They would rather hold onto the idea of getting back to where they were at almost any cost than realizing their loss and moving on to another opportunity.

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Reason #4

Why people sell commercial property too late:

Self Reliance Time Traps

Time Trap #1: Self-Education

 

People will self educate online because it is free and immediately available. A review of the search term on Google for “commercial real estate trends” returned 152 million results. A search for “commercial real estate trends YouTube” turned up 310 million results!

No doubt, an abundance of free information in the form of market data, blogs, market reports, and online opinions on what’s happening in the market is available.

Time Trap #2: Friends, Family, and Non-Commercial Advisors

 

When we aren’t sure what to do, we often consult friends, family, and non-commercial real estate advisors for input. Unfortunately, these people will not want to be the ones to say sell because it is easier to say no and risk being wrong than to say yes and risk not being right.

Plus, most of these folks will not have the data that you have seen here. These people are more likely to share anecdote based advice like “My friend made a killing in real estate. You should hold on, it will come back.” Remember, people who made this mistake lost in 2008-2010.

Time Trap #3: Hire a Traditional Broker

 

It is easy to find a traditional broker, given that 1 in 164 people in the United States today have a real estate license. According to the National Association of Realtors, there are about 2 million active real estate licensees in the United States.

The problem is that most traditional brokers do not specialize in Commercial Real Estate, Investment Sales and further specialization by property type. 

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Have you thought of selling your property and would like to know what it's worth? Request a valuation for your property below:

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https://www.creconsult.net/market-trends/the-dangers-of-selling-commercial-property-too-late/

Deconstruct Looks at CRE Investment Forecast for 2023

It’s the end of the year as we know it, and investors feel uncertain.

Rate hikes have slowed deals in the second half of 2022, and Federal Reserve Chairman Jerome Powell said there’s more pain to come.

But how long can investors’ ample dry powder sit on the sidelines?

The deal dam may break halfway through 2023, Moody’s senior economist Thomas LaSalvia said on the latest episode of TRD’s podcast “Deconstruct.”

“The market is going to have to adjust starting in the middle of next year,” LaSalvia said. “I have a feeling that we will start to see deal volume pick up a little bit more as prices maybe adjust a little bit and also as investors find creative ways to get deals done.”

But each sector holds its own nuance as rates keep rising, inflation remains high and recession looms. Multifamily’s record-breaking rent growth is likely to lose steam. Retail sales may finally feel the impact of heightened prices, and the fate of office could finally come into focus.

Tune into the full episode for a sector-by-sector breakdown of what research firms expect for 2023. The podcast will be back after a holiday break on January 9 with a new episode on Apple Podcasts, Spotify, Audible or wherever you get your podcasts.

 

Source: Deconstruct Looks at CRE Investment Forecast for 2023

https://www.creconsult.net/market-trends/deconstruct-looks-at-cre-investment-forecast-for-2023/

Chicago Becomes the Hottest Rental Market Amid a Nationwide Cooldown

While the autumn months brought a cooldown in rental prices across the U.S., some metro areas, such as Chicago, Boston, and New York, are bucking the trend with double-digit growth, according to a report out Tuesday.

In November, the median asking rent across the 50 largest metros tracked by Realtor.com increased 3.4% yearly to $1,712. According to the report, the annual growth rate was the slowest in 19 months.

“Many Americans’ budgets are being pulled in multiple directions as the holidays approach, bringing a more typical seasonal cooldown to the rental market that we hadn’t seen in the last few years,” Danielle Hale, chief economist at Realtor.com, said in a statement.

In the Sun Belt, where both sales and rental markets experienced a pandemic boom, rental prices saw the most significant cooldown. The median asking rent in Riverside, California, fell 5.5% in November to $2,071 per month. In Las Vegas, the monthly rent dropped 4.9% to a median $1,481, according to the report.

In major economic hubs such as Chicago, Boston, and New York, where there are more employment opportunities and higher concentrations of college students, monthly rents climbed by double digits compared to a year ago. Chicago experienced the largest annual growth, with the median rent increasing 20.8% to $1,949 monthly.

Boston’s median rent rose 11.8% year over year in November to $2,865 per month, surpassing New York’s monthly rent of $2,727, which was 9.4% higher than the same period last year, according to the report.

Also, the rental market is expected to remain competitive in 2023 as still-high inflation, and interest rates will deter potential buyers from purchasing homes.

“Despite this recent relief, renters will continue to be challenged by affordability in 2023, with rents forecasted to hit record highs,” Ms. Hale said.

 

 

 

Source: Chicago Becomes the Hottest Rental Market Amid a Nationwide Cooldown

https://www.creconsult.net/market-trends/chicago-becomes-the-hottest-rental-market-amid-a-nationwide-cooldown/