Projecting Returns (And What Investors Look For)
In this video I show you to quickly determine returns of of a deal, what investors look for, and how to structure the deal to achieve those returns.
The returns drive the deal. Period.
If you don’t have a model to accurately project returns for you and/your investors you’ll never be confident at making offers or raising money to buy deals.
What is the overall return?
Investors want to know what their return will be over the life of the investment. The overall return is a combination of (1) cash flow distributions, (2) paying down the loan (also called “amortization”), and (3) appreciation of the property as realized by a sale or cash-out refinance.
You add all three “profit centers” together to determine the overall return.You can take the overall return over, say, 5 years, and divide by 5 to get the average annual return.
I always consider this the most useful and easily understood way to articulate overall return. You can calculate the Internal Rate of Return (IRR) which is the more “sophisticated” way to calculate the return of any investment over time, and your more “sophisticated” investors may actually use this as a criteria.
However, I’ve found that my investors (who range from completely non-sophisticated to fairly sophisticated) respond better to the average annual return – it’s just easier to understand.
What kind of return are investors looking for?
This depends on the current market environment, i.e. what are CD rates and the stock market doing. With a somewhat flat and uncertain stock market and negligible interest rates, I have found that investors are very interested in overall rates of return of 8% – 15%.
I used to think I needed to show returns of 20% plus, but those kind of deals were extremely hard to find. Not only that, my investors actually got suspicious at the very high return. “Wow, that’s a pretty big return, so, it’s a pretty risky investment, huh?”.
For both of those reasons, look for overall returns of around 12%.
How much will the investors get paid during the year? (the Cash-on-Cash return)
While most investors care about the overall return, they also enjoy being paid during the investment, which I will refer to as “distributions”. The return from distributions is usually measured in terms of the “cash-on-cash return”, which is the percentage of distributions per year divided by the capital invested.
I have found that investors are typically happy with a 3%-8% cash on cash return.
Let’s say you take $100,000 from two investors to buy an apartment building. If you projected a 5% cash on cash return, you are saying that you plan to distribute $5,000 per year out of cash flow to your investors.
That number is after all expenses are paid out (including debt service) and must also take into consideration any distributions to you.
Preferred Rates of Return
Sometimes you can offer to investors a “preferred rate of return”, which means you agree to pay out a certain minimum before you get paid anything. Investors of course prefer this, but it is not as good for you.
For our previous example, if you agree to a 5% preferred rate of return, it would mean you pay out the first $5,000 to the investors. Anything that is left over is split according to how much equity each investor has.
Normally, the higher the preferred rate of return for the investors, the less equity I give them.
One option is no preferred rate of return, but the investors get 80% of the building. Option two is that the investors get a 5% preferred return but only get 30% equity.
I generally don’t want to give a preferred return but investors prefer it. You need to test these options with your investors to see what you need to do to get the deal done.
How to Determine the Returns and Structure the Deal With Your Investors
Now that you know the components of the overall return, you need to be able to create a model to estimate those returns.
It would require too much text to describe this in detail, so if you haven’t already, watch the video above where I show how this can be done with the Syndicated Deal Analyzer.
Thanks for watching!