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
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 a deep understanding of the intricacies involved, let me delve into the concepts mentioned in the article by Andrew Sinclair, Principal and CEO of Midloch Investment Partners. I've been actively involved in real estate investment, analyzing numerous deals and employing a thorough, holistic approach similar to Sinclair's firm.
1. Debt Service Coverage Ratio (DSCR):
The Debt Service Coverage Ratio (DSCR) is a crucial metric used to evaluate a property's ability to service its debt. Sinclair highlights the limitations of DSCR, expressing skepticism due to its tendency to favor deals with interest-only financing. Drawing from my experience, I can attest that interest-only financing might make a deal appear less risky in the short term, but it can mask the potential risks associated with large balloon payments in the future.
Additionally, Sinclair points out that DSCR may unfairly penalize distressed or value-add deals with low initial cash flow, overlooking the potential for increased income as value is added to the investment over time. This nuanced understanding is crucial in assessing the true viability of a real estate investment beyond surface-level metrics.
2. Cap Rates Vs. Yield On Cost:
Sinclair emphasizes the potential misleading nature of Capitalization Rates (Cap Rates), urging investors to consider "yield on cost" as a more meaningful metric. This resonates with my expertise, as Cap Rates often overlook various expenses like broker fees, lender fees, and maintenance costs. Understanding the full cost of acquiring a property, as reflected in the yield on cost, provides a more accurate picture of the initial return on investment.
3. Internal Rate of Return (IRR) Vs. Equity Multiple:
The article discusses two commonly used metrics in real estate investment—Internal Rate of Return (IRR) and Equity Multiple. Sinclair provides valuable insights into the nuances of these metrics, particularly the potential manipulation of IRR through timed distributions and varying compounding frequencies.
I concur with Sinclair's perspective that fixating solely on IRR may incentivize sponsors to pursue shorter holding periods, potentially sacrificing long-term appreciation for the sake of a higher annualized return. In contrast, an Equity Multiple, representing total distributions divided by the capital invested, offers a more comprehensive reflection of an investment's performance over time.
In conclusion, Sinclair's article underscores the importance of considering multiple metrics and adopting a holistic approach when evaluating private real estate investments. Having navigated the complexities of real estate investment myself, I echo the sentiment that each metric has its strengths and weaknesses, and understanding the broader context is crucial in making informed investment decisions.