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March 12, 2024

Lies, Damn Lies, and Real Estate Investment Performance Metrics


Note: A version of this article was originally published on Forbes.com.

Where to Begin

Investing in private real estate can be a challenge, I’m the first to admit.


At Midloch Investment Partners, we have an investments team that goes to great lengths to evaluate the hundreds of potential investments we consider every year. In fact, we dissect them 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. We also encourage people to review investments with their financial and tax advisers.


Still, even for professional investors like us at Midloch, some of the most common real estate performance measures can be confounding. Here’s a look at a couple of them and how we think about them. These clarifications should be helpful as you undertake your own real estate investing journey.

Debt Service Coverage Ratio

The debt service coverage ratio, or DSCR, refers to how able a property is to service its debt based on its net income. Simply put, 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 actively being repaid. 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!


A little perspective: Midloch sometimes uses interest-only financing. but our 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.


An artificially high DSCR 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 going in. For example, if a property is poorly cash flowing at the time of acquisition, the DSCR looks lousy notwithstanding the deal that we or anyone else might have gotten on a property that has really great potential to generate future income as value is added to the property.

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 start. Examples include broker fees, lender fees, due diligence costs, hard costs, and the cost of curing any deferred maintenance.


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 6.00% but a yield on cost of 5.25% when all the expenses are added in. We say look at both, and ask about both, especially if you are comparing different investments side by side.

Internal Rate of Return and 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 earned on a real estate investment on an annualized basis. That’s fair enough, but the calculation can be easily manipulated — not necessarily in negative ways but in ways that can make comparing two potential investments very difficult.


For example, distributions can be timed to inflate an IRR, and different investment managers may calculate the return based on different frequencies of compounding. IRR glosses over the notion that properties can have very uneven cash flows over time for better or worse.


The notion of IRR often incentivizes sponsors to hold properties for shorter periods … to flip them faster in order to generate the highest rate of return in the shortest period of time. So doing typically results in higher IRRs.


Yet many investments perform really well over longer periods of time based on their ability to generate cash flow consistently and often much higher appreciation as a result of longer hold periods. In this way, an investment’s equity multiple (the total distributions divided by the capital invested) can be a better reflection of its attractiveness.


Net-net: We view both metrics as important and encourage investors to do the same.


So you get the picture. All these measurements are useful, but some can be misleading in the context of evaluating deals that are hard to compare side by side.


But don’t stop trying to do it! Private real estate offers the potential to generate above-average returns relative to stocks and bonds, and has a role to play in many diversified investment portfolios.

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