As an investor you are presented with numerous opportunities to place capital: public, private, real estate, stocks, bonds, lending, venture, the list goes on. While the asset classes and corresponding returns can differ greatly, it is important to know the different types of returns when a company or general partner is pitching them to you. The below returns are some of the most commonly used when evaluating an investment opportunity. It is very important to understand the differences in terminology as it results in how and when you will receive your investment and capital returns.
Preferred Return: Entitles the investor to the first tranche of cash flow up to a certain percentage. For example, a 7% preferred return will pay the investor the first 7% of excess cash flow. This “hurdle” rate is used in most real estate private equity structures as it provides the assurances to the investor. The higher the preferred/hurdle rate, the better for the investor.
Cumulative v. Non-cumulative: Cumulative returns entitles the investor to any missed dividend payments. If an investor has a 7% preferred return but the investment company can only pay 5% due to excess cash shortfalls, the shortfall at 2% is paid at later date when there is sufficient available cash. In a non-cumulative arrangement, the investor will not receive the shortfall. Income investors should search for cumulative.
Compounded v. Non-compounded: This dictates whether the investor’s return is calculated on their initial investment only (non-compounded) or the initial investment plus appreciation (compounded). For example, if you purchase a stock for $100 and it appreciates to $110 you are then paid dividends on your $110 principal (compounded). Non-compounded only pays returns on the original $100.
Cash-on-Cash (CoC): The before tax cash flow an investment provides. A way to think about this is “take home money.” The Before Tax Cash Flow divided by the total equity investment. E.g. a property purchased for $4,000,000 requires $1,000,000 to close. In the first year, after paying expenses, debt, and capital improvements, you took home $100,000. The Cash-on-Cash return is 10%.
Internal Rate of Return (IRR): The total rate of return that factors in annual income plus future refinancing and sale proceeds. This return calculation is often misleading as it assumes several future market conditions that is impossible to know over a five or ten year period. When quoted an IRR metric, a group is modeling that they know where interest rates will be when refinancing or selling and the market conditions at that time. This crystal ball does not exist.
Equity Multiple: A very important figure in our view. This is the actual multiple on your invested cash that you receive. If you double your money = 2.0X multiple. The value of this metric is dependent upon time. The difference in receiving a 2.0X multiple over three years compared to ten is astounding. The quicker you receive your capital the quicker you can reinvest and realize the benefits of compounding.
Our GAIN Opportunity Fund employs a Cumulative, Non-Compounded, preferred return method. This entitles our investors to receive the initial 8% of excess cash flow from our properties and builds a strong portfolio foundation with the goal of exceeding the long term stock market return of 10% per year with lower volatility.