In this edition of our blog, we will review some fundamental terms and metrics used by commercial real estate professionals. These include:
Section 1031 of the US Internal Revenue Code allows the owners of business or investment real estate to defer federal taxes on the profits of properties sold as long as very specific criteria are met with regards to the sale of the existing property and purchase of another property. The idea is that the federal government is willing to allow deferment, but not elimination, of federal taxes that would otherwise be due, by encouraging investors to exchange for more expensive properties. 1031 exchanges can be fully tax-deferred or partially tax-deferred, depending on the exact situation. The four most important rules for a 1031 exchange are:
- The property purchased with the 1031 exchange sales proceeds must be “like kind”.
- The 1031 exchange proceeds must be reinvested within 180 days of the first closing, and the property being purchased must be identified within 45 days of the sale closing.
- The 1031 exchange must be reported on IRS Form 8824.
- Taxes must be paid on any “Boot” in the transaction. This taxable “Boot” is the portion of the sales proceeds you receive from a 1031 exchange that isn’t reinvested in a replacement property.
Finally, primary homes are not eligible for 1031 exchanges.
The Capitalization Rate, or “Cap Rate” as it is more often referred to, is the most fundamental and commonly used metric to evaluate commercial real estate investments by market participants. Everyone from lenders and appraisers to the smallest and largest equity investors across the globe use the Cap Rate to judge an investment opportunity or the performance of an asset.
The Cap Rate is calculated by dividing the property’s Net Operating Income (NOI) by either:
the Purchase Price, or:
the Current Market Value, or:
the Disposition Price.
In a commercial real estate investment opportunity for a land deal (or land fund), the annual cap rate would be 0% unless a land lease was signed or in place. For an investment opportunity with a Value Add profile, where the structures located on the property need significant work before they can maximize their full leasing potential, the cap rate might be artificially low or potentially even 0% for a period of time early on in the investment life, and then would rise to a more significant yield after renovations and re-leasing events occur. And finally, for an investment with a fully stabilized profile, the cap rate should remain consistent with the exception of changes in leasing or financing.
Cash on Cash Return
The Cash on Cash Return metric is a very simple, yet powerful, analytical tool used by commercial real estate investors to evaluate the strengths, and potential weaknesses or risks of a deal, as well as its ongoing performance. Cash on Cash Return is defined as Net Cash Flow divided by Total Cash Invested, and can be calculated on a periodic basis as well as for the duration of the entire investment life. Net Cash flow is the cash investors receive after all expenses are paid, and total cash invested is grand total of all equity provided by the investors.
For a commercial real estate investment opportunity on a land deal (or land fund), the annual cash on cash return would be 0% unless a land lease was signed, or a realization event were to take place. For an investment opportunity with a Value Add profile, where the structures located on the property need significant work before they can maximize their full rental potential, the cash on cash return would be low or 0% for a period of time early on in the investment life, and then would rise to a more significant yield after renovations and re-leasing events occur. And finally, for an investment with a fully stabilized profile, the cash on cash return should remain consistent with the exception of changes in leasing or financing.
The Internal Rate of Return, or IRR, is a metric utilized by most real estate investors that is a more precise measurement of a property’s long-term yield. Not only is it more precise, but it is also more difficult to compute than the Cap Rate or Cash on Cash Return. While IRR is more complex than these measures, it also takes into consideration time value of money, which the aforementioned metrics do not. Essentially, IRR is the percentage of interest the investor earns on their investment, but it is more precisely defined as the discount rate that makes the Net Present Value (NPV) of all cash flows (both positive and negative) over time equal to zero. As with the other metrics discussed, IRR has its limitations, and is not a perfect stand-alone metric, but it can be very powerful when used appropriately alongside various other metrics.
The Equity Multiplier, also known as the Equity Multiple, or EM, is a metric that calculates the expected total return on an investment. Mathematically, the Equity Multiplier is calculated as Total Distributions divided by Total Invested Capital.
For example, if an investor buys a particular piece of land for $1,000,000 and sells it six months later for $2,000,000, then the Equity Multiplier is equal to $2,000,000 / $1,000,000, or 2.0. This number is then often stated as “2.0x”.
In another example, an investor purchased another commercial real estate investment for $1,000,000 on an all-cash deal. Over each of the 10 years of ownership, the investor earned $100,000 of cash flow, and when they sold the property at the end of year 10, they netted $3,000,000. In this scenario, the Equity Multiplier is equal to [(10 x $100,000) + $3,000,000] / $1,000,000, or 4.0. Again, this would typically be stated as “4.0x”.
At first glance, time might not be an evident factor in the Equity Multiplier equation, however, time is very critical to this metric. In the second example above, the investor held this particular piece of commercial real estate for ten years, and each year added 0.1x to the final Equity Multiplier. This same investment, if sold in year 5, at the same final value of $3,000,000, would only have an Equity Multiplier of 3.5x. This tells us that when we evaluate deals, we should keep in mind that this metric, like all others mentioned here, are not perfect, stand-alone metrics. Alternatively, when the Equity Multiplier is paired and evaluated alongside the IRR, the two become incredibly useful together.