In this article, we will take a look at the most common metrics that are used to evaluate your overall investment performance. Each of the metrics answers a different question, and you should pay attention to what you are trying to evaluate. Usually, articles go from simple to complex, but we will dive right into the most holistic metric and go from there.
But first, here are some of the questions you might have and what is the best metric to use:
- Overall, how did my investment perform, taking into account the time/value of money?
- What was my average annualized return at the end of my investment?
- What percentage of my initial investment did this investment return?
IRR – Internal Rate of Return
We will start with the most complex metric to calculate – IRR or Internal Rate of Return. We are starting with IRR, because this is the best metric to use when calculating the overall performance of an investment and the best way to compare one investment to the other. The reason this is the most accurate method is that the IRR calculation takes into account not just the amount of return but also the timing of each distribution. Because money returned earlier in an investment cycle is worth more than money returned later, we can actually evaluate what, in theory, could be our return at the end of an investment. We will get back to the “in theory” part later, but first, let’s take a look at a few examples of how different distributions can impact the IRR.
| Year | Transaction Date | Example 1 | Example 2 |
|---|---|---|---|
| Year 1 – initial contribution | 1/1/2019 | -$100,000 | -$100,000 |
| Year 1 | 12/31/2019 | $6,000 | $6,000 |
| Year 2 | 12/31/2020 | $7,000 | $27,000 |
| Year 3 | 12/31/2021 | $8,000 | $8,000 |
| Year 4 | 12/31/2022 | $158,000 | $138,000 |
| Total Return | $79,000 | $79,000 | |
| IRR | 16.86% | 18.18% |
Let’s take a look at the 2 examples above. The total return over the 4 years has not changed, but Example 2 has an extra $20,000 distribution along with the $7,000 for the year. For the sake of this example, let’s say that the investment had a refinancing event, which resulted in a larger distribution. In Example 1, our overall IRR is 16.9%, while in Example 2, it is 18.2%. This is because IRR takes into account not just the amount but also the timing of each distribution event.
Based on this example, you can see how two seemingly identical investments can have different IRR. Which investment is better? Obviously Example 2, the sooner we get the return on capital, the sooner we can re-invest it.
Let’s get back to the “in theory” part of our sentence. Well, we say “in theory” because the IRR formula assumes that any return you get can be reinvested immediately for the same return on investment rate. So in both examples above, the assumption is that in year 1, you can take the $6,000 you get back and reinvest it in another investment that would overall return 16.9% or 18.2% return. The reason it is “in theory” is because, realistically, if you only have $6,000 to invest, first, you might not find a suitable investment immediately. Second, the new investment might not have the same returns.
Nevertheless, IRR is the best way to compare one investment to another, and you will always see the IRR defined in any offering materials.
IRR – Calculation
How do we calculate IRR? The formula is complex and, frankly, not worth trying to figure out. The easiest way is to use the Excel or Google Sheets built-in function XIRR. All you need is a series of dates and the corresponding amounts. Go ahead, try it out with the able above and have fun playing with it!
IRR – Pros & Cons
One other problem with IRR is that we cannot calculate IRR while the project is ongoing, as we do need to take into account both return of capital, as well as the time of each distribution. So what do we do during an ongoing project? One option is to use AAR.
Pros
- Takes into account the time value of money
- Best way to compare apples-to-apples different investments
Cons
- Cannot be calculated mid-investment
- Assumes returns are immediately reinvested at an identical returns investment
- Complex formula
When to use: Comparing potential investments and completed investments
Question Answered: Overall, how did my investment perform, taking into account the time/value of money?
AAR – Average Annual Return
AAR or Average Annual Return can give us the answer to “What was my average annualized return at the end of my investment?”, as well as “What IS my average annualized return?” With AAR, we do not need to wait for the full cycle of the investment to be done, and at any point of the investment, we can calculate what the AAR is.
Calculating the AAR is simpler – we add each of the annual returns and divide the sum by the number of years.
Let’s take a look at an example:
| Year | Transaction Date | Example 3 | Annual Return % | AAR |
|---|---|---|---|---|
| Year 1 – initial contribution | 1/1/2019 | -$100,000 | ||
| Year 1 | 12/31/2019 | $6,000 | 6% | 6% |
| Year 2 | 12/31/2020 | $7,000 | 7% | 6.5% |
| Year 3 | 12/31/2021 | $8,000 | 8% | 7% |
| Year 4 | 12/31/2022 | $158,000 ($100,000 return of capital) | 58% | 19.75% |
In year 2, our AAR is (6%+7%)/2 = 6.5%. In year 3, our AAR is (6%+7%+8%)/3 = 7%, and so on. You can see that we can calculate AAR at any point of our investment, which can be useful in monitoring how the investment is doing even before it has been completed.
You can, however, also see that we jump pretty quickly to a much higher AAR at the end of the investment. In most investments, you will get most of your return at the end, so while your AAR might start lower by the end, you will see a big jump in AAR.
AAR can be a good calculation as your investment makes distributions to quickly evaluate how you are performing against the preferred return specified by the sponsor.
AAR – Calculation
The formula for AAR calculation is:
[(1+r1) x (1+r2) x (1+r3) x … x (1+ri)] (1/n) – 1
Where r is the annual rate of return and n is the number of years in the period.
The simpler way to look at it is that AAR is calculated as the sum of all the annual returns divided by the number of years. In Example 3 this is (6% + 7% + 8% + 58%) / 4 = 19.75% .
Pros
- Can be calculated at any point in the lifetime of an investment
- Easy to calculate
- It can be used to compare multiple investments but has drawbacks vs. IRR.
Cons
- It can be misleading especially if there are periods of negative returns.
- It does not take into account the time/value of money.
When to use: Comparing active investments, Completed investments when not considering the benefits of re-investing.
Question answered: What was my average annualized return at the end of my investment?
Equity Multiple
We are not a fan of the Equity multiplier metric alone; however, sponsors often use this as part of their marketing materials and presentations. We are not a fan of it on its own because it does not account for the concept of time. Would you like to get a 2x multiplier on your investment? I am guessing the answer is “yes.” But not so fast… What if I ask you if you would like to get a 2x multiplier on your investment in 5 years? How about a 2x multiplier in 10 years? That is a very different question. The equity multiplier alone is not a good measure of returns. So if someone promises any kind of a multiplier, your first question should be – “In what time period?”.
Let’s take a look at an example:
| Example 4 | Example 5 | Example 6 | |
|---|---|---|---|
| Invested | $100,000 | $100,000 | $100,000 |
| Gain | $100,000 | $100,000 | $100,000 |
| Total Distributions | $200,000 | $200,000 | $200,000 |
| Equity Multiple | 2 | 2 | 2 |
| Years | 5 | 10 | 15 |
| AAR | 20% | 10% | 6.7% |
In the example above, we calculate AAR by dividing the gain ($100,000) by the time period. You can see that the time it takes the investment to complete has a tremendous impact on our Average Anual Return. Back to our questions above, We are sure your answer is Yes to Example 4 and not Example 5 (2x multiplier in 5 years and not 10).
Equity Multiple – Calculation
Equity multiple is calculated by dividing the total distributions by the invested amount:
Total Distributions / Invested Amount
The total distributions include the return of capital upon sale.
Pros
- Quick communication about the return on investment
Cons
- It cannot be calculated mid-investment.
- Alone means nothing without specification of time
- It does not take into account the time/value of money
When to use: As a warning for potential sponsor scams, but seriously only use this metric as a casual conversation along with the time period and never alone.
Question answered: What percentage of my initial investment did this investment return?
Conclusion
As a passive real estate investor, it is important to be aware of the top-used metrics for evaluating performance. IRR, AAR, and Equity multiple can all be used to answer different questions about your investment, and you should be familiar with all of them and the best situations to use them.
We hope this helps you with your next investment opportunity evaluation.
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