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Apartment Financial Underwriting - Part 2 of a 2 Part Series

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Investment Yield Ratios

In Part 1 of this series, we covered the basic organization and structure of an apartment proforma, income and expense summary, and a construction cash flow schedule.

In this 2nd part, we'll cover investment yield ratios that we utilize as a professional development company, to analyze the return characteristics to determine if a project is worthwhile in our initial underwriting, as well as, provide final financial return reporting on completed projects.

In the development business, these are the major financial ratios used to measure investment yields on equity investment by professional developers, institutional level and mid-size equity investors:

Internal Rate of Return

Equity Multiple

ROI or Cash on Cash

Internal Rate of Return

First, the textbook definition:

Internal rate of return (IRR) is the interest rate at which the net present value of all the cash flows (both positive and negative) from a project or investment equal zero.

Internal rate of return is used to evaluate the attractiveness of a project or investment. If the IRR of a new project exceeds a company's required rate of return, that project is desirable. If IRR falls below the required rate of return, the project should be rejected.

Now, the real world definition:

IRR is the rate of return produced by investing equity into a development project at the beginning of a project's investment cycle (this could be cash used for predevelopment costs, land close, and funds for construction) and getting repayment of original investment plus yield on the invested capital at the end of the project. The major advantage to using IRR, is that it takes into account the time/value of an investment, and allows IRR or rates of return to be compared between investments with different time cycles. You can compare an equity investment for a project that takes 1 year to invest and repay, to a project that takes 7 years to invest and repay, then choose which produces the higher IRR. This is why IRR is used by sophisticated and institutional level investors.

Understand this: the longer an investment takes timewise, the more likely the total IRR will be lower and trend downward. As well, the opposite is true, if the investment time cycle of a project is very short, the IRR could spike very high, especially when an investment period is under one year.

Once the first dollar of equity is invested then the clock to calculate the IRR starts and ends upon the final repayment of the original equity investment, any preferred return (called "pref") and the backend profit splits allocated to the equity investor. We'll explain more about the practical aspects and presentation of IRR's when we write about raising capital in the equity markets.

One item to remember: IRR is not an assessment of risk, and is an assessment of generated returns on invested equity over a given time period. Although IRR can be used to compare investment choices as stated above, you as the developer must make an assessment of risk and any associated mitigations to risk in order to effectively compare potential investments.

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Equity Multiple

First, the textbook definition: A ratio dividing the total net profit plus the maximum amount of equity invested by the maximum amount of equity invested. The Equity Multiple (EM) of an investment does not take into account when the return is made and does not reflect the risk profile of the offering or any other variables potentially affecting the project’s return.

There basic formulaic structure for EM:

Equity multiple = cumulative distributed returns / paid-in equity


Equity multiple = paid-in equity+yield on equity / paid-in equity

The way I think of equity multiple pragmatically is this: What's the ratio of the dollars I get back based on dollars I put in? EM is a way to measure the whole dollar return of the project given the investment. Many times an institutional investor or fund wants to achieve a certain amount of dollars back from the investment, say 2 dollars for every dollar invested, or a 2.0 equity multiple. This can help them measure and account for the time, energy, and money they invested. Is it worth investing in, if it does or does not return a certain amount of whole dollars?

As an example: An equity multiple of 1.3 is less attractive to an investor versus 2.0 multiple. EM is a static measurement and does NOT account for the time value of money in the measurement. It just says plainly: How much money do I invest, and how much money do I get back, and what is that ratio?

Example: We invested $50,000 in equity in the project, and received total distributions of $100,000. So our EM is 2.0. But, if the time period for the payout was 18 month the IRR might be 40%, but if paid over 10 years the IRR might be 15%*.

* these examples are simplified for this explanation and are not real measurement of yield.

You really want to use IRR and Equity Multiple in tandem, each to measure yield on the project in different ways. IRR is a dynamic measurement of yield that accounts for the time value of money and total investment returns over time. EM is that ratio or measure of the total magnitude of generated yield in terms of whole dollars.

Cash on Cash (COC) Return or Return on Investment (ROI)

COC/ROI = Yield*/Paid-In Equity

* In this case, yield could be total profits generated from the sale of property, or it could be annualized cash flows from income producing projects.

This is a simplified method of calculating yields on equity investments. It is (or can be) a dynamic measurement of yield if applied to ongoing cash flows generated from net rental income. When applied to a one time capital event, a sale for example, it is a static measurement. Some non-institutional investors use ROI as their preferred measurement, in many cases because calculating IRR is a more complicated calculation. But like EM, it does not take into account net present values of cash flows over time, and therefore is not completely accurate and usable to compare alternative investment choices. For our company, we like to use COC to measure the potential annual net cash flows when underwriting development projects that may be long term hold candidates.

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