When evaluating real estate investments, investors can use several key metrics to assess the potential risk and return of an investment. By analyzing these calculations alongside other fundamental principles, investors can make informed decisions tailored to their financial goals and risk tolerance.
Here we share an overview of common metrics. Our conversation is based primarily on topics presented in the textbook titled “Commercial Real Estate Analysis and Investments,” third edition, by David M. Geltner, Norman G. Miller, Jim Clayton, and Piet Eiccholtz. (For advisors who want to take a deep dive into commercial real estate, this is a great reference book.)
Calculating Investment Performance
Return metrics are designed to quantify investment performance of individual properties as well as portfolios, funds, and segments of the asset class at large. We can consider historical or realized returns (ex post) as well as expected future returns (ex ante).
Period-By-Period Returns
These metrics calculate investment growth within a single period of time, assuming all cash flows or asset valuation happens at the beginning or end of the period. Periodic returns allow real estate performance to be measured in the same way as traditional assets, such as stocks and bonds.
Total return
Total return includes the change in capital value of the asset during the period as well as any income paid out by the asset to the investor during the period.
𝑟𝑡=(𝐶𝐹𝑡+𝑉𝑡−𝑉𝑡−1)/𝑉𝑡-1
In this formula, r refers to the total return during period t. V represents the market value of the asset. CFt occurs at the end of period t. The return depicts a scenario where the asset is bought at the beginning of the period then sold at the end the period; however, the lack of interim cash flow may not reflect reality for a real estate investment. The longer the period, the greater the inaccuracy created by the reality that not all cash flows occur at the end of the periods.
The periodic total return can be broken into two parts: income and appreciation. The income return is calculated as y for the period t.
𝑦𝑡=𝐶𝐹𝑡/𝑉𝑡−1y
Real estate market participants may also define income return as NOIt / Vt-1. (See below for more information about NOI, or net operating income.)
Appreciation return measures the change in the asset market value during the period. This return is also known as capital return, capital gain, price-change component, or growth. It is calculated as g for the period t.
𝑔𝑡=(𝑉𝑡− 𝑉𝑡−1)/𝑉𝑡−1
The total return during period t is the sum of the income and appreciation return:
𝑟𝑡=𝑦𝑡+𝑔𝑡
MultiPeriod Returns
Investors typically want to know the average return earned over multiple periods. We can approach this by calculating time-weighted or money-weighted average returns.
Time-weighted average return
We can calculate a time-weighted average return form a series of periodic returns using a simple arithmetic average, or a geometric average. For example, the arithmetic average of periodic returns of 8%, 8%, and 10% per year is 8.7%. The time-weighted average is not affected by the timing of capital flows into or out of the investment.
Internal rate of return (IRR)
IRR is a money-weighted average return. It reflects the effect of having different amounts of money invested at different periods during the overall life of the investment. It is an “internal” rate because capital withdrawn from the investment no longer influences the metric.
IRR is the most commonly used multiperiod return measure in real estate. IRR can be calculated without knowing the capital value of the investment at intermediate points in time. This makes IRR a convenient measure for analyzing real estate investments that are not frequently marked to market. Think about a typical real estate investment held for several years: We only know the exact value of the asset at the beginning and end of the investment, when the property is bought and sold—but we know the cash flows generated by the asset along the way. Because IRR is a money-weighted measure, it gives a better picture of the performance of an investment manager who has control over interim cash flows.
Calculating IRR requires the purchase price, the net cash flow generated by the property during each period, and an estimate of what the property is worth currently or its sale price. PV represents the amount invested in year 0 and CFt represents the net cash flow in year t. Intermediate cash flows can include cash flow from operation of the asset, partial disposition, or subsequent investments after the initial purchase. N is the year the asset is sold. CFN includes net operating cash flow in year N as well as the salvage value or net proceeds from the final sale.
The equation is solved using the IRR function in Excel or a financial calculator.
IRR sample scenarios
Suppose you plan to invest $100,000 in one of two real estate investments. The sponsors for each investment estimate $150,000 of cash flow to be repaid over seven years. The first investment offers immediate payment of $5,000 per year for the first six years, then a payment of $120,000 in year seven. The second investment offers no payment for the first two years, then $30,000 per year through years three to seven. Investment B produces a better IRR, even though you must wait two years to see any cash flow.
| Investment A | Investment B | |
| Invested | ($100,000) | ($100,000) |
| Year 1 | $5,000 | $0.00 |
| Year 2 | $5,000 | $0.00 |
| Year 3 | $5,000 | $30,000 |
| Year 4 | $5,000 | $30,000 |
| Year 5 | $5,000 | $30,000 |
| Year 6 | $5,000 | $30,000 |
| Year 7 | $120,000 | $30,000 |
| IRR | 6.7% | 8.6% |
Importantly, IRR may not adequately capture when the money is distributed if the sponsor only quotes the total expected IRR for the project. It is possible to have two potential investments with the same IRR where one produces annual income while the other produces income at the end of the investment’s life. In the example below, Investments A and B produce the same IRR, yet their cash flow profiles are quite different.
| Investment A | Investment B | |
| Invested | ($100,000) | ($100,000) |
| Year 1 | $0 | $30,000 |
| Year 2 | $0 | $30,000 |
| Year 3 | $0 | $30,000 |
| Year 4 | $0 | $30,000 |
| Year 5 | $203,000 | $30,000 |
| IRR | 15.2% | 15.2% |
Net Operating Income (NOI)
NOI is a widely used indicator of a real estate investment’s net cash flow or operating profit. NOI is calculated by subtracting operating expenses from rental revenue.
Some market participants believe a more accurate measure of bottom-line net cash flow available for distribution from building operations would subtract necessary capital improvement expenditures. NOI minus capital improvement expenditures is often called property-before-tax cash flow.
Capitalization Rate (Cap Rate)
When comparing property prices and values, market participants commonly think in terms of property value per dollar of current net income, except that the inverse ratio is used. This measure is called the capitalization rate (cap rate), which is the property’s net operating income divided by the asset price or value.
While cap rates are helpful and widely used, investors should be aware that cap rates are a simplified valuation tool with some shortcomings—for example, cap rates are less reliable if a property has irregular or changing cash flows. A more thorough analysis would include careful consideration of the property’s ability to generate net cash flow from its operations over the long term.
Caliber’s Advisor Resource Hub
To learn more about alternative investing and real estate, visit our Advisor Resource Hub or contact our team today.
About Caliber (CaliberCos Inc.) (NASDAQ: CWD)
With more than $2.9 billion of managed assets, including estimated costs to complete assets under development, Caliber’s 16-year track record of managing and developing real estate is built on a singular goal: make money in all market conditions. Our growth is fueled by our performance and our competitive advantage: we invest in projects, strategies, and geographies that global real estate institutions do not. Integral to our competitive advantage is our in-house shared services group, which offers Caliber greater control over our real estate and visibility to future investment opportunities. There are multiple ways to participate in Caliber’s success: invest in Nasdaq-listed CaliberCos Inc. and/or invest directly in our Private Funds.
Investor Considerations
The information contained herein is general in nature and is not intended, and should not be construed, as accounting, financial, investment, legal, or tax advice, or opinion, in each instance provided by Caliber or any of its affiliates, agents, or representatives. The reader is cautioned that this material may not be applicable to, or suitable for, the reader’s specific circumstances, desires, needs, and requires consideration of all applicable facts and circumstances. The reader understands and acknowledges that, prior to taking any action relating to this material, the reader (i) has been encouraged to rely upon the advice of the reader’s accounting, financial, investment, legal, and tax advisers with respect to the accounting, financial, investment, legal, tax, and other considerations relating to this material, (ii) is not relying upon Caliber or any of its affiliates, agents, employees, managers, members, or representatives for accounting, financial, investment, legal, tax, or business advice, and (iii) has sought independent accounting, financial, investment, legal, tax, and business advice relating to this material. Caliber, and each of its affiliates, agents, employees, managers, members, and representatives assumes no obligation to inform the reader of any change in the law or other factors that could affect the information contained herein.
Sign Up For Our Newsletter!
Stay up to date on Caliber fund updates and more.