Commercial real estate is an efficient way to diversify your portfolio. It does not trend with the markets, has lower volatility than stocks, and can serve as a hedge against inflation. Investing through syndications is one of the most affordable ways to get into commercial real estate and allows you to diversity across multiple properties and markets.
When vetting commercial property, you want to evaluate financial metrics to determine if the rate of return is worth the risk. But how do you know if you have found the right opportunity? And what financial metrics provide the best assessment of risk and return?
Below are the most common financial ratios used by investors to gauge the quality of a deal and estimate its profit potential.
Cap Rate or Capitalization Rate is a fundamental financial metric describing the potential investment return. The Cap rate looks at the potential return over a one-year period but does not consider indebtedness. To calculate, divide the NOI (net operating income) by the current market value or acquisition cost. Cap rates for multifamily commercial properties tend to range from 6 to 8%.
IRR, or Internal Rate of Return, measures an investment’s profitability and strength. The metric represents the profits an investor might receive over the entire hold period taking into account the time value of money. The calculation considers the initial investment, cash flow, and applicable discount rates. The higher the IRR, the more profitable the investment.
The IRR does not quantify the dollar amount you will receive. Therefore higher cash flows do not always make it a superior investment. Instead, it tracks how quickly you will recoup your investment dollars. Multifamily projects tend to offer IRRs between 12 and 15%
GOI or Gross Operating Income establishes the capital required (or revenues needed) to operate the property. GOI shows the property’s yield, includes all revenue sources and subtracts vacancy and credit losses.
NOI or Net Operating Income helps investors determine the profitability of a particular investment. To calculate, subtract operating expenses from gross revenues. Debt is the only expense not included in NOI.
Cash-on-cash or CoC return describes the cash yield and quantifies the potential annual return. The metric divides the yearly pre-tax cash with the initial cash investment. It measures the amount of money you can expect to earn each year of the hold period. Most CoC returns range from 8 to 12%.
GRM or Gross Rent Multiplier considers the market value of the property and the annual gross income of the property. This metric does not include loan amortization, operating expenses, or market fluctuations.
Preferred Return sets the minimum profit investors will receive before sponsors or managing partners receive payouts. Cumulative preferred returns allow the preferred return to accumulate until paid. The preferred return protects limited partners by paying them a percentage of the profits before managing partners receive payments. Most commercial real estate syndications offer a preferred return ranging from 6 to 8%.
DSCR or Debt Service Coverage Ratio measures the risk of encumbering the property with loans by measuring the cash flow in relation to the NOI. The metric helps lenders and the managing sponsor establish a cap on lending. Most lenders approve a loan amount that produces a DSCR between 1.25X and 1.5X.
To learn more about investing in multifamily real estate syndications with McKee Capital Group, watch our introductory video here.