Return on equity/cash on cash calc

I'm looking at a cash flow statement. What line items do you include in free cash flow, including a disposition, to arrive to your yearly and all in cash on cash return on investment. Do you include yearly fund level accounting in the cash yield? Broker sale cost? Prepayment on debt? etc... I've seen many opinions on what to include here, as well as what is included in IRR. Even spoke with a professor of finance who has 20+ years in PE, however his answer was very vague and can be summed up as 'be honest, know your partners, model everything yourself.'

thoughts?

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Comments (14)

Sep 14, 2017 - 5:07pm

Having seen this being done by other RE funds I've worked with as well as being the person who does financial modelling for a REIT myself:

  • Cash yield /cash on cash return = Distributions (dividends+sub debt interest and principal repayments) i.e cash in hand for the end investor

Divided by

  • Cash contributed (equity + sub debt)

I mention sub debt because most real estate transactions I've seen are financed with sub debt (i.e debt subordinated to the senior debt) instead of pure equity, sub debt is usually "stapled" to share capital i.e if Investor 1 puts in 20% of the sub debt, they also put in/own 20% of the share capital.

Do not look at accounting costs for sub debt as that can often include rolled up interest: i.e interest accrues but isn't actually paid out. Also do not look at free cashflow on it's own as the definitions of that vary and it isn't necessarily what is paid out to the investors.

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Sep 14, 2017 - 5:15pm

I see. Interesting. So you're saying you see a lot of sponsors or the REIT invest in a different part of the capital stack as a pref equity/participating debt, in addition to the equity?

Okay. So this is helpful. I spoke with a guy who wanted everything included in the calc, accounting fees, lawyers, sale costs, etc. If you include all items that occur during a sale, you take a huge hit to returns. My understanding was always cash = cash after operations, debt, and admin stuff below the line on the income statement, not items that occur during a transaction, which only occurs once (or twice if you refi.)

Best Response
Sep 14, 2017 - 5:38pm
youngunner:

I see. Interesting. So you're saying you see a lot of sponsors or the REIT invest in a different part of the capital stack as a pref equity/participating debt, in addition to the equity?

Okay. So this is helpful. I spoke with a guy who wanted everything included in the calc, accounting fees, lawyers, sale costs, etc. If you include all items that occur during a sale, you take a huge hit to returns. My understanding was always cash = cash after operations, debt, and admin stuff below the line on the income statement, not items that occur during a transaction, which only occurs once (or twice if you refi.)

Yes, equity and sub debt are often interchangeable. Although this can vary, but I've not seen many transactions where the % sub debt owned by an investor differs from the % equity owned. For your cash on cash calc, it doesn't really matter as the mechanics are the same- cash received over cash contributed, regardless of where you sit in the capital structure.

Sub debt, depending on the tax rules in your country, can give a bit of a tax benefit as the cost of the coupon can be a (partially) deductible expense against taxable profits.

Yes, you have to factor in transaction costs to your returns. Take this example:

  • You're acquiring an asset that costs 90, plus you have to pay another 10 to lawyers/accountants/advisors. Your total cost is 100.

  • You finance with 50% senior debt and the rest is equity.

  • In year 1 you receive 5 of distributions. Your cash yield is 5/50 = 10%. It doesn't matter what your accounting profits were, it doesn't matter what cash from operations was, what matters is what you pocket. That is cash on cash.

AB84:

Cash-on-Cash and IRR are different.

I could be wrong, but annual C-o-C excludes capital events proceeds. It only looks at cash flow from operations over your equity contribution.

As far as IRR. The best way to think of it is this: model out every single dollar you invested and received and when you invested and received those dollars.

Well depending on assets, sales of assets or capital event proceeds can be a normal part of owning that portfolio. Therefore any money received from these is a part of your income. However yet again your C-o-C yield looks at what you distribute over what you contribute.

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Sep 14, 2017 - 5:46pm

Okay. So proceeds from a sale are not 'distributions,' nor are fees taken out of sale proceeds (lawyers at exit for example, or broker sale cost at exit). I think that is what you are saying, which is what I have always thought...

The alternative would be to also count proceeds from sale, which would be a huge coc positive impact.

Sep 14, 2017 - 5:28pm

Cash-on-Cash and IRR are different.

I could be wrong, but annual C-o-C excludes capital events proceeds. It only looks at cash flow from operations over your equity contribution.

As far as IRR. The best way to think of it is this: model out every single dollar you invested and received and when you invested and received those dollars.

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Sep 15, 2017 - 6:04pm

Cash on Cash Y2 Onwards (Originally Posted: 05/31/2017)

So most of us know how to calculate the Cash on Cash metric for the first year of a projects life span (annual Y1 cash flow / total cash invested).

What I am interested in is how the denominator (total cash invested) changes from years 2 onwards. Is this fixed (because the initial cash invested will obviously never change) or will investor contributions (i.e. major CAPEX requirements) and/or return of investor capital (i.e. a refinance) change this denominator in years 2 onwards?

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Sep 15, 2017 - 6:05pm

In general, yes, but it's always dependent on how the deal is structured. Assuming you have a preferred return to profit split structure, upon a capital event such as a refinance you would pay off the original debt on the property, then any accrued unpaid preferred return to the investors, then the rest would be a return of capital. You would take the return of capital amount and deduct it from your investor's initial equity amount, which now becomes your new COC denomintor.

Sep 15, 2017 - 6:06pm

In general, if you have to put additional capital into the deal, then your denominator (aka equity invested) will increase. As mentioned above, an extraordinary capital event (refinance, sell of 1 parcel of a multi-parcel deal, etc.) will reduce the demonstrator, and therefore increase your cash on cash going forward (given the calculation is now based on the equity outstanding, not your original amount).

As an FYI: if your model is set up monthly, then I would be cautious in what capital you add to your denominator. For example, if you are trying to calculate cash on cash for a stabilized office deal, odds are that on monthly calculations, you will have negative cash balances due to TI & LC payments. However, when looking at this on an annual basis, you very well could be cash flow positive (aka, you would be paying for these TI / LC payments from operational cash flow, NOT a capital call).

Sep 15, 2017 - 6:07pm

OK great thanks guys that is exactly what I was looking for - I assume the definition of a "capital event" will need to be defined as per the partnership agreement?

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