“Our portfolio is up 11% this year.” -Traditional Portfolio Investor
Investors in the public markets oftentimes gauge the performance of their investments by a single metric. A quick glance at a brokerage home page will show the current market value of holdings and the percent change in the value of those holdings over various lengths of time into the past — one year, three years, five years, etc. Investors tend to evaluate performance purely on this year-over-year basis. Only three variables are needed for this calculation —current value, initial value, and the number of periods. These variables are the inputs needed to calculate this performance metric — the compound annual growth rate (CAGR).
(Current value / Initial value) ^ (1 / number of periods) – 1
The formula is a useful tool, specifically for evaluating and comparing mutual funds in the public markets. It is also more valuable than the average annual growth rate, which fails to capture any value (or loss) from the effect of compounding.
In contrast, investments in private markets tend to be evaluated through a number of different lenses, where no one metric alone gives a full picture of the performance of an investment over time. Understanding the values and shortcomings of each metric can provide savvy investors confidence when evaluating both current positions and projected returns in potential investments.
Let’s illustrate this with the following example of two hypothetical investment scenarios. In both cases, an initial investment of $100 is made on Dec. 31, 2014, held for five years, and culminates with current market value (based on an assumed sale) as of Dec. 31, 2019. Scenario 1 paid no dividends until the sale, whereas Scenario 2 made annual distributions.
How, as an investor, can you determine which of the two investments was better in retrospect, and conversely, had you been presented with these two opportunities, which would have been preferable? To answer either question, multiple metrics should be evaluated.
The internal rate of return (IRR) remains the gold standard for evaluating investments in the private markets. Mathematically, it is the discount rate that sets the net present value (NPV) of an investment equal to zero. In any case where the IRR of a project exceeds the investor’s discount rate (cost of capital), the NPV will be positive and the project should be pursued. In other words, it is the equivalent annual compound rate of return the investment would generate over a specified period of time. It is ideal for measuring investments with multiple cash flows and periods and captures the time component of the investment that is lost in multiples-based metrics.
In our example above, Scenario 1 has an IRR of 19.1% and Scenario 2 has an IRR of 19.5%. In retrospect, the investments are thus fairly comparable, but Scenario 1 may have been deemed riskier because the return was entirely dependent on the terminal value. Like the other metrics to be discussed, IRR is a useful metric for understanding performance, but it tells the investor nothing about the source, and therefore risk, of potential cashflows.
The compound annual growth rate was discussed previously for its role in understanding public market portfolios. It is most useful when there are no subsequent cash inflows or outflows, which would be captured by the IRR, and when the investor is less concerned about any volatility between the initial investment and the current value. Though infrequently used in private real estate, it could be a relevant tool for understanding an investment such as a ground-up development, which produced no interim cash flows and experienced limited (or no) volatility between the initial investment and the sale date.
In the example above, Scenario 1 had a CAGR of 19.1% whereas, Scenario 2 had a CAGR of 12.5%. Of course, this fails to capture any of the distributions to the investor in Scenario 2 (assuming they were not somehow reinvested), and for this reason, it is often ignored by investors in income-producing investment entities.
The cash-on-cash return, also known as yield, is a critically important metric for most real estate investors. This calculation reveals the annual cash distribution(s) as a percentage of the original investment. It is frequently averaged over the life of the investment. Beware, however, of offerings that include sales proceeds in the average annual cash-on-cash metric.
Scenario 1 paid no dividend distributions until the sale in year five. It, therefore, had four years with a cash-on-cash return of 0%, and a final year with 240%. Including this terminal value produces an average annual yield of 48%. This is a higher amount than Scenario 2, which produced a 44% average annual yield. Of course, Scenario 2 paid 10% in each of the first four years and a 180% return in the final year. Despite the average being slightly lower, some investors may prefer this choice as distributions began earlier, and these could then be invested elsewhere. In this Scenario, 40% of the capital was returned prior to the sale in the final year.
The equity multiple (EM) is the simplest calculation but perhaps the least revealing about the investment. It is computed by dividing the total distributions during the life of the investment by the initial investment. Unlike the IRR, however, it fails to factor in any value of time. Scenario 1 has an EM of 2.40x ($240 / $100) whereas Scenario 2 has an EM of 2.20x ($220 / $100). It is best used to compare two similar investments, each preferably without periodic cash flows and with an equivalent time horizon. To further clarify, an EM of 2.40x is a significantly better return over a period of three years than a 2.40x multiple over a 10-year investment.
The summary of metrics discussed for the two scenarios is consolidated in the table below:
|Scenario 1||Scenario 2|
|Cash-on Cash with Proceeds||48.0%||44.0%|
|Cash-on-Cash without Proceeds||0.0%||10.0%|
So, which investment is better?
The answer depends on your cash needs and risk tolerance as an investor. Over the same period of time, Scenario 1 ultimately delivered more cash on the investment ($240 vs $220); however, Scenario 2 made earlier distributions and returned 40% of the capital prior to the sale. That early return may take some risk off the table to investors, and it drove the IRR higher for Scenario 2. The shortcoming with the IRR computation, however, is that it assumes those early returns of capital are reinvested at the same rate – to the extent they are not, then the return in Scenario 1 may, in fact, be higher.
When evaluating a potential investment, it is up to you as an investor to understand the risks to the project delivering the underwritten cash flows, deciding the value of early distributions, and understanding the time horizon of the investment. Overreliance on a single metric may lead to poor investment decisions. Each investment should be evaluated from many angles and by the metrics most relevant to that type of investment. At Timberland Partners, we invest for both income generation and long-term capital appreciation. We place significant value on the annual yield on our investments, and also on the estimated IRR (based on an assumed liquidation) as we believe this metric best captures interim cash flows, the increase in value, and the duration of the investment.