CP16: What KPI's should a passive investor track?

Today on another episode from our education series, Duc and Vince talk about Key Performance Indicators (KPI’s) that a passive investor should track. A limited partner (or silent partner, as we talked about in the last part of the series), needs to be aware of some aspects of a deal when evaluating an offer. You have to make sure that you’re asking the right questions about the deal, and also ensure that the details you’re provided match the risk profile that you’re comfortable with. But unfortunately, a lot of times, people don’t know what these aspects entail, or even have no clue what they mean in the first place! With these metrics provided, we hope that you can make better decisions on what you’re willing to accept based on your risk profile 

Cash-on-Cash Return on Investment

It’s the rate of return that calculates the cash income earned on the cash invested. The formula would be cash invested divided by the cash flow before taxes. It’s very simple, but it’s one of the foundational metrics that many seem to ignore because what people look for are complex ones that we’ll be getting into a little later. But essentially, the higher cash-on-cash ROI early on in a project means a safer investment. The faster your capital is returned to me, the safer the investment is going to be. As far as the equity is concerned, you’re generally looking at an eight percent cash ROI at acquisition.

Average Annualized Return (AAR)

This is a percentage used when reporting the historical return on investment. That means the entire project, including the sales and the exit. It will average all of those years across each other. With that said, AAR’s can hide some of the poor performance early on in a project. For example, on projects that you do value adds, the first year or two will be really low (or even negative), but you might have a big sale at the end. Because the AAR is an average, it hides some of that part of the process, which might make you reconsider an offer.

Internal Rate of Return (IRR)

The IRR is the rate of return needed to convert the sum of all future cash flows to equal the initial equity investment. It’s taking out all future cash flows and discounting them back to zero. The IRR’s difference with AAR’s is that the IRR takes time into account, while the AAR does not. While some people think it’s the pinnacle of investing metrics, we don’t. One of its limitations is that it doesn’t tell you the timing of the cash flows related to the project’s risk profile. It doesn’t answer how fast you’ll get your money back. For example, we can think of two projects that have the same IRR. One is more of a flip that gets you your sale at the end of five years, but nothing in the first four years and the other is a project where you get decent cash-on-cash ROI on the first four years and a modest appreciation at the end. 

Head on over to the Cashflow Project to hear the rest of the metrics you’ve been missing! The more you know, the better.

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Outline of the Episode:

• What are cash-on-cash returns on investment?
• What is an average annualized return (AAR)?
• How about internal rate of returns (IRR)? Why do people love them so much?
• What is an equity multiple?
• Capitalization rates (cap rates), prevailing cap rates, cap rates at acquisition, terminal cap rates, and reversion cap rates.

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