So you have researched the market, looked at some projects, attended a tax auction or two and read everything about Charleston SC real estate investing that you get your hands on? Along the way, you have frequently come across terms used by the industry when it comes to measuring performance. You can now “talk the talk, ” but can you “walk the walk? ” Have you really understood what they mean and how to use them? Let us look at a few by way of example:
IRR – Internal Rate of Return. IRR is a term used to quantify the percentage return on the cash invested in a deal. 10% is not great, 20% is good, 50% and you are in the money (if you can ever find a deal like that!).
- IRR is the return on cash invested in a deal FOR THE PERIOD it is invested. So, for example, a deal can produce cash flow which is paid out annually or the cash can be reinvested in the deal and not paid out until the end of the deal. Given the same starting conditions and same year 1 cash flow, the latter will produce a higher IRR than the former.
- It also allows you to compare two similar deals to decide which one provides the best return assuming all other parameters are substantially similar.
- IRR can be on a “Cash on Cash ” basis i.e. it assumes that 100% of the starting equity needed for the deal is a cash investment or, it can be “levered ” i.e. it makes allowance for a percentage of bank finance. Levering is a way to directly improve the IRR on a deal assuming that Cash on Cash IRR is higher than the cost of finance. We have written specifically about the benefits of “levering ” in an earlier blog.
So far so good? Let’s look at another commonly used one. DCR or DSCR – Debt Service Coverage Ratio. You will need to understand this if you ever apply for a commercial loan from a local bank.
- This is the wiggle room that a Bank needs to give them comfort that the project can cover its outstanding loan payments. It is based on NET operating income after all operating expenses but before finance costs, divided by those finance costs.
- A DCR ratio of 1.0 means that 100% of net income goes to pay for the mortgage which is not a great place to be! A ratio of less than 1.0 and you will be in trouble paying for the right to keep the lights on. In reality, the deal needs to offer a DCR above 1.2, preferably above 1.5, so that there is additional cash to cover unexpected repairs, market turbulence and any number of snafu’s that were not considered in your initial plan.
Still awake? Now for the last one for today: NPV – Net Present Value.
- NPV shows you if your deal is achieving your target return. NPV is the value of all future cash flow from an investment discounted back to a point in time minus the cost to achieve that cash flow. $1.0 today at 10% interest is worth $1.10 in a year. Similarly $1.10 a year from now discounted at 10% will have an NPV of $1.0 today.
- So in analyzing a deal if your NPV is positive you are paying less than an asset is worth to achieve your desired rate of return: negative you are paying more than you should: neutral then you are paying exactly what its worth to you at the discount rate you have selected (aka your desired return).
- We could get all technical and say it’s a measure of the present value of future money but whats the point in confusion?
NOTE: So there you have it. A “hopefully ” simple explanation of three of the terms you are likely to encounter as you expand your asset base to include real estate investments. Want to know more? Download our free “Guide to Investment Terms used in Real Estate. ” Happy reading!
