Andrew Sinclair is Principal and CEO of Midloch Investment Partners, a real estate investment fund manager based in Chicago.
Investing in private real estate can be a challenge.
At my firm, Midloch Investment Partners, we have an investments team that goes to great lengths to evaluate hundreds of investments every year. In fact, we thoroughly dissect potential investments to be able to compare them side by side—apples to apples, if you will.
If you’re an individual investor, this is a tough road to go yourself. But it’s certainly possible to analyze the investments you may be considering for your own portfolio. I also encourage individual investors to review investments with their financial and tax advisers.
Still, even for investors like us, some of the most common real estate performance measures can be confounding—which is why we never make or reject an investment based solely on a single metric. Instead, view each prospective investment holistically.
Here’s how we think about a couple of key real estate investment performance measures. This perspective should be helpful as you undertake your own real estate investing journey.
Debt Service Coverage Ratio
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The debt service coverage ratio, or DSCR, refers to how able a property is to service its debt based on its net income. In mathematical terms, it's the net operating income divided by the mortgage payment on a property.
DSCR is one of my least favorite statistics for two reasons.
First, it makes deals with interest-only financing look artificially better than deals where the loan principal is being repaid actively. Said another way, it makes deals with interest-only financing look more attractive than deals with amortizing mortgage loan payments. Yes, it makes often riskier deals look artificially less risky simply because the debt payments are lower!
To be sure, I sometimes use interest-only financing, but my preference is to lock in interest rates and pay down loan principal to immediately increase equity. That’s generally part of our conservative approach to investing in the first place. But making larger payments to the lender does lower the DSCR.
In contrast, an interest-only loan produces a higher DSCR. This can create a false sense of security, especially given that interest-only loans typically come with large balloon payments (the debt balance), which is not recognized by the DSCR metric.
A second downside to DSCR is that it penalizes distressed and value-add deals with low cash flow at the time of the initial investment. For example, if a property is cash flowing poorly when it’s acquired, the DSCR looks lousy, notwithstanding the discount that we or anyone else might have gotten on a property that has great potential to generate future income as value is added to the investment and it generates more income. You get the picture.
Cap Rates Vs. Yield On Cost
Cap rates are another interesting metric, but they can be misleading as well.
Cap rates refer to the going-in yield, or the yield at the time of an acquisition. Most people calculate the cap rate as operating income divided by the price paid for a property.
It’s seemingly straightforward, but cap rates typically overstate the initial return because they don’t account for a host of other expenses that figure into the basis of a property at the onset. Examples include broker fees, lender fees, due diligence costs, hard costs and the cost of curing any deferred maintenance. These costs are not recognized by the cap rate.
One senior member of my team views “yield on cost” as a more meaningful metric than cap rates for this reason. All those expenses cited above are part of the cost of acquiring a property and should be considered as such. Looking at an investment both ways might reveal a cap rate of 6% but a yield on cost of 5.25% when all the expenses are recognized. I say look at both, and ask about both, especially if you are comparing different investments side by side.
As a value-add investor, I don’t view the lower yield on cost as a negative because, by the time we make a decision to acquire a property, we’ve already identified at least two or three ways to unlock the investment’s value and grow its net operating income to become attractive.
Internal Rate Of Return Vs. Equity Multiple
Two of the most commonly used real estate investment metrics are internal rate of return, or IRR, and equity multiple. They’re both relevant and meaningful for different reasons. They’re even complementary, but they have their weaknesses as points of comparison among various investments.
IRR essentially refers to the income and long-term profit, including capital gain that’s earned on a real estate investment, as calculated on an annualized basis. That’s fair enough, but the number can be easily manipulated—not necessarily in negative ways, but in ways that can make comparing two potential investments very difficult.
More specifically, distributions (cash payments to investors) can be timed to inflate an IRR, and different investment managers may calculate the return based on different frequencies of compounding. For example, to make the IRR appear higher, many managers will compound the IRR on a monthly basis as opposed to an annual basis. Why? Because of the power of compound interest.
A fixation on IRR often incentivizes sponsors to hold properties for shorter periods; in other words, to flip them faster in order to generate the highest IRR in the shortest period of time.
Yet many real estate investments perform really well over longer periods of time based on their ability to generate cash flow consistently and produce much higher appreciation as a result of longer hold periods. In this case, an investment’s equity multiple (the total distributions divided by the capital invested) can be a much better reflection of its performance.
Bottom line: All of the metrics discussed here are important, and I encourage investors to view them that way, without fixating on any one. It’s the context of the broader picture that matters when evaluating private real estate investments to include in a diversified investment portfolio.
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As an expert in real estate investment, with years of experience leading Midloch Investment Partners, a respected real estate investment fund manager based in Chicago, I bring a wealth of knowledge to the table. My team and I rigorously evaluate hundreds of investments annually, dissecting each potential opportunity with precision. This depth of experience allows us to navigate the complexities of the real estate market, making informed decisions that contribute to the success of our investment portfolio.
One of the key aspects we consider in our evaluations is the Debt Service Coverage Ratio (DSCR). This metric, which measures a property's ability to service its debt based on net income, is often misunderstood. I emphasize the limitations of relying solely on DSCR, as it can present a skewed view, especially when dealing with interest-only financing. Our conservative approach involves locking in interest rates and actively repaying loan principal to enhance equity, recognizing that interest-only loans can create a false sense of security.
Another critical metric we scrutinize is the Capitalization Rate (Cap Rate). While commonly used, Cap Rates can be misleading as they don't account for various expenses associated with property acquisition. We advocate for considering the "yield on cost" as a more meaningful metric, taking into account all expenses related to acquiring a property. This approach provides a comprehensive view, revealing a more accurate initial return when comparing different investments side by side.
In the realm of performance metrics, Internal Rate of Return (IRR) and Equity Multiple are two commonly used benchmarks. While both are relevant, IRR can be easily manipulated, potentially leading to challenges in comparing investments. We caution against fixating solely on IRR, as it may incentivize short-term property flips to maximize the rate. Instead, we emphasize the importance of considering Equity Multiple, which reflects the total distributions divided by the capital invested, providing a more comprehensive reflection of an investment's performance over a longer horizon.
In conclusion, I advocate for a holistic approach when evaluating private real estate investments. Each metric plays a crucial role, but it's the context of the broader picture that truly matters. Whether it's understanding the nuances of DSCR, recognizing the limitations of Cap Rates, or navigating the complexities of IRR and Equity Multiple, a well-informed and balanced perspective is essential for success in the dynamic world of real estate investing.
