Assessing the Performance of Real Estate Investments

Since the earliest days of property ownership, individuals have sought ways to gauge the success of their investments. In this chapter, we explore various methods, ranging from traditional cash flow measurements to more advanced techniques like internal rate of return, providing insights relevant to contemporary investors. Starting with age-old metrics like the payback period and cash-on-cash return, we progress to sophisticated tools like the gross rent multiplier and debt coverage ratio.

The payback period, a venerable and straightforward measure, quantifies the time required to recover the initial cash investment. For instance, if a property, purchased for R500,000 with a R100,000 cash investment, generates a R20,000 annual cash flow, the payback period is five years. Although easy to understand, the payback period overlooks the time value of money, treating future dollars as equal to present ones.

Similarly, the cash-on-cash return, expressed as a percentage, compares the annual cash flow to the initial cash investment. While providing a simple rate of return, it is limited by its focus on a single year, potentially offering a skewed perspective.

The gross rent multiplier (GRM) estimates a property’s value by evaluating it as a multiple of its gross rental income. Despite its simplicity, GRM remains useful, especially in precomputer times. By analyzing comparable sales and establishing a rent multiplier, GRM offers insights into a property’s potential value.

Introducing a cousin to cash flow measures, the debt coverage ratio assesses the ratio between annual net operating income and annual debt service. Widely used in financing considerations, it provides lenders with information about a property’s ability to meet mortgage payments. A debt coverage ratio of at least 1.20 is often required by lenders.

While these measures shed light on investment quality, they are not comprehensive. The timing of income streams and the impact of property resale are critical considerations often overlooked by traditional metrics. With the advent of personal computers and powerful software, investors can now employ more refined analyses, incorporating factors like resale and cash flow timing. Advanced measures such as capitalization rate and discounted cash flow allow for a nuanced understanding of real estate investments, offering a more holistic perspective on their success from acquisition to disposition.

Capitalization Rate

The concept of “capitalization rate” or “cap rate” has been previously explored. To recap, cap rate is defined as the ratio between a property’s net operating income (NOI) and its value.

Capitalization Rate=NOIValueCapitalization Rate=ValueNOI​

Net operating income (NOI) is derived from gross scheduled income, adjusted for vacancy and credit loss, and reduced by operating expenses. These expenses include items such as insurance, utilities, and maintenance, excluding mortgage payments, depreciation, capital expenditures, and income taxes. In essence, NOI represents net income before debt service, capital costs, and income taxes.

Unlike the gross rent multiplier (GRM), cap rate focuses on net operating income, considering revenue after deducting operating expenses. The widespread use of cap rate in the real estate industry makes it a valuable tool for comparing a property’s current performance with that of similar properties. Market cap rates are readily available, allowing investors to assess whether a property is underachieving or overachieving relative to the market.

However, like other metrics discussed earlier, cap rate has limitations. It provides a snapshot of the property’s performance at a specific point in time, typically the current year, without considering its expected performance over the entire holding period. While useful for estimating the property’s present value and potential resale value, it lacks a comprehensive view of performance over time, as investors commit to the entire timeline of ownership.

Derived Capitalization Rate

To understand cap rates further, it’s essential to explore the derivation process, introducing the concept of “band of investment” or “derived cap rate.” This approach dissects the market cap rate into two components: financing and equity. The derived cap rate becomes the weighted average of these two components.

Consider a property purchase with 20% equity and 80% financing. Assuming loans are available for 15 years at 7%, the financing component, or lender’s cap rate, is calculated using the mortgage constant. The investor’s cap rate involves deciding on a risk-adjusted safe rate, reflecting the T-bill rate adjusted for the additional risk of real estate investment.

While this derivation may seem complex, it provides valuable insights. By analyzing the components, investors can gain an understanding of the cash-on-cash return prevalent in the market. For instance, if the market cap rate is 11%, and typical financing is available at 7%, an investor can estimate achieving a 12% cash-on-cash return in the first year of ownership.

Discounted Cash Flow

An investment’s essence lies in the present worth of an anticipated future income stream. This definition forms the basis for discounted cash flow analysis (DCF), a powerful tool that considers the time value of money and uncertainties associated with future projections.

DCF involves discounting the anticipated future income stream, encompassing cash flows for each year of the holding period and the eventual sale of the property, back to a present value (PV). This approach accounts for both the magnitude and timing of investment returns.

Choosing an appropriate discount rate is crucial for effective DCF analysis. The discount rate should represent the expected rate of return in a comparable investment with a similar risk profile. DCF can be applied to various income streams, including NOI and gross selling price for appraisers, or actual cash flows after taxes and net sale proceeds after taxes for investors.

This comprehensive analysis, considering leveraging effects through financing and taxation, provides a nuanced understanding of the property’s value and investment performance. While not a rate-of-return measure, DCF offers a more sophisticated evaluation compared to earlier techniques, enabling investors to make informed decisions based on the entire income stream’s present worth.

Internal Rate of Return

If you’ve followed along this far, you’re on the brink of unraveling a concept that often baffles investors: internal rate of return (IRR).

Internal rate of return (IRR) occupies a somewhat dubious position among various investment metrics. It stands out as the most frequently used and cited rate of return in real estate, yet it remains one of the least comprehended. The next time someone pats you on the back and declares a property’s IRR, inquire, “Can you elaborate on what that truly signifies?” I’ll wager you my recent acquisition of a local suspension bridge in a friendly card game that the response, if any, will be indecipherable.

Understanding IRR becomes more accessible through incremental comprehension rather than attempting a giant leap. Fortunately, the preceding material has equipped you with the necessary groundwork.

Once again, let’s step back just enough to gain momentum. We defined an investment as an expected stream of income, with the present value (PV) of that investment being the sum of the discounted values of each future cash flow. In simpler terms, the investment generates cash flow annually—ideally positive, but possibly negative. Upon disposing of the investment property, you realize an additional cash flow—the proceeds from the sale.

The longer you wait to collect your money, the less its “PV” today. As reiterated throughout this book, there is a time value to money.

Your real estate investment will produce periodic cash flows, usually estimated on an annual basis for simplicity. A cash flow received today is valued at face value, but each expected future cash flow must be discounted to its lower PV. Once you sum the PVs of these future cash flows, you arrive at the PV of the entire income stream. Since the income stream represents your investment, you now possess the present worth of that investment.

Consider one more example: You acquire a building today, operate it for five years, and then sell it. The actual cash flows are as follows:

You believe these future cash flows should be discounted at 11%. This implies that you think if you had R25,000 in hand today, you could invest it at an average return of 11% per year over the next five years. You base this assumption on the observation that similar property investments currently yield about 11% to their owners. For every year you lack one of these cash flows in hand, you estimate a potential loss of an 11% return, hence the discount applied to each.

The PV of each cash flow, discounted at 11%, appears as follows:

Summing these up results not in the R25,000 face value, but R15,564.92. This represents the total present worth of the expected future cash flows, including the resale. If you’ve made accurate projections and chosen an appropriate discount rate, it’s reasonable to assert that the future economic benefit from the property is worth about R15,565 today.

Does this mean the property itself is worth R15,565? If you pay all cash without additional acquisition costs, then this is indeed the value of the property to you as an investor seeking an 11% return. However, in reality, this statement needs rephrasing: Given these cash flows occurring at these points in time, R15,565 is the amount you, as an investor seeking an 11% return, would be willing to invest.

The sum of the discounted cash flows always represents the value (i.e., what you’re getting for) your cash outlay. If you purchase a property for all cash, the sum of the discounted cash flows equals the property’s value since that is the amount you’re investing. If you finance the purchase, the sum of the discounted cash flows represents the value of just your cash outlay.

Keep in mind that if you finance the property, you have reduced cash flow due to debt service, and you have fewer sale proceeds due to mortgage payoff. When discounting these smaller cash flows, the result aligns with your cash outlay, which is also less than the full property value in a leveraged investment.

At last, we arrive at the core. Until now, you’ve assumed knowledge or projection of future cash flows and the discount rate to estimate the present worth of those cash flows. But what if you already know the present worth of the future cash flows?

If you know the actual cash investment (purchase price less financing and acquisition costs), you’re essentially stating, “If I proceed with this deal under these terms, then the cash I must bring to the table is, by definition, the present value of the future cash flows.” But at what discount rate?

Previously, you used future cash flows and a discount rate to calculate the PV of your investment. Now, similar to solving for a different variable in eighth-grade algebra (which this isn’t), you’re going to solve for the discount rate. Once found, this rate is labeled the IRR.

Let’s articulate this once more: If I know or can project future cash flows and the appropriate discount rate, I can calculate the PV of my cash investment.

If I know or can project future cash flows and the PV (i.e., the amount) of my cash investment, I can calculate the discount rate, which I’ll then designate as the IRR.

(A note of caution: Don’t attempt to manually calculate IRR for a series of cash flows and a cash investment. IRR requires a binary search or “successive approximations” technique, which might make you forget why you sought the answer in the first place. There are painless ways to find IRR: Financial calculators and Microsoft Excel can perform this task. We offer a basic Excel model for download at Additionally, you can use user-friendly income-property analysis software, such as that provided by RealData.)

IRR surpasses many other measures of investment quality because it considers both the magnitude and timing of every cash flow. Initially challenging to grasp, it is elegantly straightforward. Discount all future cash flows from their occurrence back to the present using a single discount rate. Once you find the unique rate that makes the sum of these discounted cash flows equal to the initial cash investment, you’ve identified the IRR.

Let’s use the data from the previous example to try some IRR computations. You can employ an Excel model that applies the IRR function to a series of cash flows:

(This model is available for download at In each of the first four years, you have a positive cash flow of R1,000.

In year 5, you have combined cash flow and sale proceeds of R21,000. Let’s assume your initial cash investment is R15,565. Enter these amounts into the model:

Your IRR is precisely 11%. Should this surprise you? Not at all, as this computation is essentially the reverse of what you did in the previous PV example. There, you had the same cash flows for years 1 to 5, but you specified a known discount rate (11%) to compute the PV. Here, you specify the PV (how much cash you’re going to invest) to compute the overall discount rate (the IRR).

It should be evident that the more you pay to receive the cash flows, the lower your overall rate of return will be. Conversely, if you pay less for them, your rate of return will be higher. Let’s say you pay only R14,000:

Now you’re faring better—better, in fact, than the typical investor in your area, who you determined was getting 11%. What if you pay R17,000?

Clearly, this is much less appealing. You assert to yourself, and probably to the seller, the broker, and everyone else within earshot, that if other properties are yielding 11%, settling for 8.84% is not acceptable.

But hold on, there’s more to this story. You’ve been focused on the idea of holding the property for five years. What if you hold it for more or fewer years? Now you’ll need to make additional forecasts about cash flow beyond five years and about the selling price in years other than 5. In real life, events might not unfold precisely as forecasted, but for the sake of simplicity and to illustrate a crucial point about IRR, let’s make the following assumptions. Stick with the R17,000 cash investment that displeased you in the last example. Also, assume that the annual cash flow will consistently be R1,000, and the resale price will be R20,000, irrespective of when you sell. This allows you to focus on the element of timing. Try selling the property two years earlier than planned (end of year 3) and two years later (end of year 7).

Here’s the scenario at the end of year 7:

Now, at the end of year 3:

What just happened? Clearly, your cash flow isn’t an impressive figure with this property; the payoff occurs with the resale. If you delay that resale by an additional two years to year 7, then the proceeds represent even less to you in current rands, and your IRR on this investment decreases. On the other hand, if you expedite the receipt of the substantial payoff, those proceeds are more valuable to you in current rands, increasing your IRR. In fact, it increases to about 11%, making this deal appear acceptable if you don’t hold beyond the three-year horizon.

Typically, neither cash flows nor potential sale proceeds remain static. Cash flows might fluctuate (for example, more repairs one year than another), but the general expectation is upward over time. Moreover, the potential cash proceeds from selling the property are expected to grow as the property’s value increases due to rising net operating income (NOI), and the mortgage balance diminishes.

IRR wields more analytical power than most other measures of investment quality due to its sensitivity to both the timing and magnitude of cash flows. Now is when you can truly start to enjoy playing with the numbers and leveraging their power to guide you toward sound investment decisions. For instance, by using the cash flows and potential resale proceeds, you could calculate the IRR if you held the property for one year and then sold it, or for two years, three years, and so on.

Rule of Thumb: When forecasting for a property, don’t limit your analysis to a single holding period (e.g., five years, as in our case study). Examine as many different holding periods as possible, and observe if there’s a year where the IRR peaks. If so, this is the year to consider selling to maximize your return. If there’s no definitive peak but rather a range of years with a consistent IRR, that indicates no optimal sale year, and you can sell whenever it suits you.

Imagine you run a five-year forecast on an income property, including a potential sale in each of those years. The resulting IRRs are as follows:

Here, you notice that the IRR peaks in the third year. In other words, if you operate the property as planned and sell it at the end of three years, your rate of return for that period would be higher than for any other holding period. In a scenario like this, IRR is more valuable than a simple rate-of-return calculation. If the IRR peaks, it identifies an optimal holding period. Investors unfamiliar with IRR might complain, “This doesn’t make sense. My IRR peaks at the end of year 3, but my cash flow from operations is increasing in years 4, 5, and beyond, as is the resale value of the property. How can the IRR decrease when everything else is rising?”

It can, it often does, and it shouldn’t be disregarded. Picture this: You acquire a property and successfully revamp it. In the first three years of ownership, you upgrade it physically, enhance its management, and significantly boost its rent roll. Once stabilized and running smoothly with all leases at market rents, you continue to enhance income, but at a more moderate rate of growth.

So, why does the IRR decrease after year 3? Recall that the IRR is sensitive to the timing and magnitude of cash flows. In the first three years, you elevated the cash flow from operations and potential cash proceeds from resale at an impressive rate. In the fourth year, you increased them again, but at a considerably lower rate. Remember that the substantial cash flow increases occurred early, making them particularly valuable—due to the time value of money, these cash flows are discounted less severely since they occur earlier. Not only are the later cash flow increases smaller, but they are discounted over a greater number of years. If you hold the property for four years instead of three, that fourth year dilutes the overall rate of return because (a) it wasn’t as robust as each of the first three and (b) it had to be discounted even more since it occurred yet another year later.

None of the subsequent years in this example match the performance of the first three, so every additional year of holding the property further diminishes the overall return. In this analysis, the IRR delivers a potent and perhaps surprising message: “Don’t be deceived by the fact that you show cash flow increases every year. Your most significant impact was in the first three years. That’s when you should consider cashing out and repeating this process somewhere else.”

Now that you’ve mastered cash flow, resale, and IRR, you’re not restricted to searching for an optimal holding period alone. What happens to your IRR if you secure a larger mortgage and use less cash? How about if you do the opposite? If you invest in improvements that enable you to raise rents, will that enhance or diminish your return?

This sounds promising; you’ve seemingly discovered the perfect metric for measuring your investment’s return. But hold on—the standard application of IRR has a few shortcomings. Sometimes its results are imperfect, even misleading. Let’s move on to the potential issues with IRR and explore potential solutions.

Financial Management Rate of Return and Modified Internal Rate of Return

As we concluded the last section, a realization dawned – a shift in perspective from the discounted cash flow’s present value to solving for the rate, the internal rate of return (IRR). This measure emerged as a robust indicator of investment return, sensitive to the interplay between the timing and magnitude of cash flows.

IRR, a significant improvement over static metrics like cash-on-cash return and gross rent multiplier, proved more informative than net present value (NPV). Yet, like any compelling narrative, there’s more to explore.

While IRR is widely accepted, it has its critics. The issues with IRR arise when cash flows deviate from their regular pattern. Scenarios involving negative cash flows, such as a projected increase in financing interest rates, unfunded repairs, or tenant uncertainties, can pose challenges for IRR calculations.

In cases with multiple sign changes in cash flows, IRR may present “nonunique” results, offering several mathematically correct solutions. This can be problematic for decision-making. For instance, a series of cash flows showing three sign changes could yield IRRs of 0%, 100%, and 200%.

Furthermore, IRR’s assumption about reinvesting positive cash flows at the same rate as the IRR itself may not align with reality. The safe rate (or finance rate) and reinvestment rate (or risk rate) become crucial in addressing these issues.

Safe rate: This is the interest rate at which you secure funds in a secure and liquid form to cover future negative cash flows. The safe rate is used to discount negative cash flows back to the nearest positive cash flow.

For example, if you predict a negative cash flow of R15,000 at the end of year 1 and could put cash aside at a 4% safe rate when making your initial investment, then the amount needed would be R14,423.

Reinvestment rate: This is the rate at which you assume you can reinvest all positive cash flows. Unlike IRR’s assumption, this rate acknowledges that positive cash flows may be reinvested at different rates.

To address the shortcomings of IRR, two modified metrics come into play: Financial Management Rate of Return (FMRR) and Modified Internal Rate of Return (MIRR).

FMRR: It eliminates negatives by discounting them back at the safe rate to the nearest previous positive cash flow. Remaining negatives are discounted back to the initial investment time (year 0) at the safe rate. Positive cash flows are then compounded forward at a realistic rate.

MIRR: A variation that often demands less computation power than FMRR. It discounts all negative cash flows to year 0 and avoids the complexity of matching individual negatives with offsetting positives.

To compare mutually exclusive investment alternatives, capital accumulation (CpA) comparison comes into play. While not a rate-of-return measure, it evaluates accumulated dollars, helping compare investments with different upfront cash requirements and holding periods.

In summary, the alphabet soup of metrics – NPV, DCF, IRR, FMRR, MIRR, and CpA – offers a diverse toolkit. The smart investor understands these techniques, considers them all, and selects the most suitable one(s) for the specific investment decision at hand.