For real estate investors conducting a thorough financial analysis of a real estate development project is critical before placing your hard earned capital. A small change in one assumption could completely swing a project from success to failure. From a returns perspective development provides savvy investors an opportunity to generate returns well above the public markets if the right projects are chosen.
In this multiple part series we will focus on a few key metrics or key performance indicators (KPI’s) that can help you assess the overall returns of the project you are reviewing.
How do real estate investors participate in a development project?
Real estate development projects involve costs upfront to acquire the land, financing, construction costs, and more to get the project off the ground. The construction takes place and then once the building is built it is either sold or rented out to be held for cash flow. The construction period can vary and so real estate investors place capital at early stages in the project with an expectation of a payoff after construction is completed.
Accredited investors would typically participate as limited partnership (LP) investors where they place capital with a real estate developer. The LP investor does not provide personal guarantees on the development loans and the “at risk” amount is limited to the capital they invest. For example, if you invested $100,000 on a development project in Surrey, British Columbia with a real estate developer your liability for the project in the event of a default would be capped at the $100,000 invested.
Let’s get into the Deal Metrics!
To start with in this article, Part 1, we will focus on overall deal metrics. Stay tuned for future posts in this series where we dive into construction cost metrics and then finally stabilized property returns. As you are evaluating real estate development opportunities our team at Finalyze Real Estate CFO Services would be pleased to help you evaluate investment opportunities and help guide you on your real estate investing journey. Please reach out at Info@FinalyzeCFO.com for a complimentary consultation.
Here are our top 3 metrics when evaluating the overall deal of a real estate development project:
- Internal Rate of Return (IRR) – The most common metric used to evaluate real estate investments. As the saying goes, time is money. A dollar is invested today with an expectation of a greater payoff in the future. The IRR metric lays out the cash inflows and outflows by date for the life of the project. The end result is a calculation such as 15%. An investor would say if I am getting 15% on this project how does this compare to other projects I could invest in? Am I getting compensated for the risks taken here?
- Equity Multiple (EM) – Real estate investors are commonly told “hey invest your funds here we will double your money in 2 years!”. The equity multiple is a simple way to determine this multiplier. Unlike IRR this metric does not factor in the timing of the cash flows but rather is a simple calculation that takes Total Cash Received divided by Total Cash Invested. If I invested $100K in a project and it gave me $200K then I have an equity multiple of 2x. The issue here is what if it takes me 10 years to earn that $200K back? Now my cash is locked in for longer versus perhaps another project might give me a 1.5x multiple over say 2 years.
- Return on Investment (ROI) – A quick measure of the profitability of an investment by simply comparing the the net profit and dividing it by the initial investment. The ROI calculation is expressed as a % such as this project is generating a 30% ROI.
In addition to the above metrics a major consideration is leverage which involves the amount and % of debt of being used on a project as this impacts returns and overall risk especially in a changing interest rate environment.
In Part 2 of this series we will dive into construction and development cost metrics. Investors need to evaluate if the project is being run efficiently and if the construction costs are reasonable as this greatly affects overall returns.
Our team at Finalyze Real Estate CFO Services would be pleased to assist you in your real estate investing journey. Our unique Plan, Raise, and Manage approach can support your investment objectives throughout the investment lifecycle. We are pleased to be the trusted advisor to real estate investors, developers, and investment funds in Canada and the United States. Please reach out at Info@FinalyzeCFO.com or www.FinalyzeCFO.com to learn more about our services.