In a commercial real estate investment, it is normal for a property’s operational performance to vary from year to year. So, by extension, it is also normal for property values to rise and fall in response to the property’s operational performance. While this is to be expected, price volatility can make it difficult for investors to measure annual growth in a multi-year investment period. Fortunately, there is a metric designed to solve just this issue: CAGR.
In this article, we will discuss compound annual growth rate, or CAGR for short. We will describe what CAGR is, how it is calculated, and why it is useful in commercial real estate investing. By the end, readers will have the information needed to calculate the CAGR metric as part of their pre-investment due diligence process.
At First National Realty Partners, we calculate an entire suite of performance metrics for each potential investment property. In doing so, we are able to identify the deals that have the greatest probability for a profitable outcome. These are the ones we present to investors. To learn more about our current investment opportunities, click here.
What is Compound Annual Growth Rate (CAGR)?
The compound annual growth rate (CAGR) is a performance metric that is designed to provide investors with an indication of an investment’s year-over-year growth rate. In doing so, CAGR “smooths” out annual volatility over a multi-year forecast period.
To put this point in perspective, let’s go through the CAGR calculation formula and an example.
How to Calculate CAGR
The formula used to calculate the CAGR is:
CAGR =( (Final Value / Starting Value)^(1/t) ) – 1
In other words, the CAGR is equal to the final value of the investment divided by the initial value, raised to the power of one divided by the number of years over which the CAGR is being calculated (t). While the CAGR calculation may seem complex, it is rarely performed manually. Instead, the “RRI” function can be used in Excel to calculate CAGR quickly and easily.
To illustrate how the CAGR calculation works, both manually and in Excel, an example is helpful.
CAGR Calculation Example
To simplify this example, assume that the property does not produce any income. We are going to look at value only.
Suppose that an investor purchased a multifamily property for $1MM and planned to hold the property for five years. The following table summarizes the estimated value at the end of each of the five years:
From the table, it can be seen that the price rises in years 1-3, but then market dynamics cause it to drop in year four before resuming its climb in year 5. These changes are depicted in the chart below:
To smooth out the irregular changes, the CAGR can be calculated. This calculation is shown both manually and using the Excel function below:
Manually: CAGR = ($1,520,000 / $1,000,000)^(1/5) – 1
Excel: CAGR = RRI(# Years In Holding Period, End Value, Start Value) OR RRI(5, $1,520,000, $1,000,000)
In either case, the answer is the same, 8.73%. To highlight what this means, look at the same value table again:
|Year||EOY Value||CAGR Value|
In this version, a “CAGR Value” column has been added and the property value is increased annually by the amount of the CAGR. In other words, the value is increased by 8.73% each year and, by year 5, it gets to the same ending point of $1,520,000. This can be seen by the updated graph, which shows the “smoothed” increase over the same five year period:
The key takeaway is this, the CAGR calculation smooths out the volatility associated with year to year changes in value and provides investors with an ideal of the annual return experienced over a multi-year holding period.
What is a Good CAGR?
Like many performance metrics in commercial real estate investing, the question of “good” is a relative one. Each investor may have their own individual growth targets. One investor who prioritizes growth over safety may require a CAGR north of 10%. But, another investor whose primary concern is preservation of capital may be comfortable with a 5% CAGR.
Each investor should evaluate their own individual preferences and investment objectives and target investments with a CAGR that meets their needs and requirements.
Uses of CAGR in Commercial Real Estate
Traditionally, CAGR is used to evaluate the performance of companies, but it has a few helpful uses in the commercial real estate sector.
1. Comparing Investments
Each real estate deal is unique in its own right so creating a true “apples to apples” comparison can be tricky. However, CAGR provides investors with a way to compare the growth rates of respective investment opportunities. If one deal has values that grow at an annual rate of 7% and another has a growth rate of 9%, it may be safely assumed that the value of the second property is growing faster, which increases the chances for a profitable outcome.
2. Tracking Investment Performance
CAGR is often calculated at the beginning of an investment, sometimes even prior to when the property is purchased. As a result, it also acts as a useful way to track the investment’s actual performance relative to the initial estimate. For example, suppose an analyst estimates a CAGR of 8% for a real estate deal, but the actual CAGR in the first year of the investment turns out to be 6%. In such a situation, the analyst could review this comparison and take corrective action. For example, they could take steps to increase occupancy / reduce the vacancy rate or lower operating expenses. If successful, these initiatives could get the growth rate back on track.
3. Finding Weaknesses & Strengths
To the point above, deviations in CAGR from the original prediction would cause an analyst to perform some research on the property, the real estate market, the financial statements, market trends, and the general competitive landscape to determine why the deviation occurred. In doing so, they may be able to identify the strengths and weaknesses of the deal. For example, they may discover that the actual rental rates are lower than originally predicted, which is causing less cash flow than modeled. Or, they may discover that the physical condition of the property is in worse shape than they imagined, which requires higher maintenance costs than predicted. In either case, they can make adjustments to improve property performance in the coming years.
Limitations of CAGR Calculations
As a performance metric, CAGR is useful for many reasons, but it isn’t perfect. Investors should be aware of two key limitations when using the CAGR to evaluate a potential investment:
CAGR measures growth only. It does not account for risk, which is a very important component of evaluating a commercial real estate investment. Seasoned CRE investors know that it is important to evaluate qualitative aspects of a property such as its leasing activity, market growth grates, market segmentation, tenant company profiles, and the key players in the market to determine the risk profile of an investment. If they looked at the CAGR alone, they would miss these elements of the deal.
2. Constant Growth
The CAGR also implies that the growth rate is constant over time. As the example above shows, this is not usually the case. In reality, values can go up and down based on changes in the US market or broader global commercial real estate industry. So, investors should not be lulled into thinking that a property’s value will grow by the same amount, every year.
For these reasons, the CAGR should not be used to evaluate a potential investment in isolation. Instead, it should be used as one input in the broader due diligence process to determine if an opportunity is the right fit.
Summary of CAGR in Commercial Real Estate
The Compound Annual Growth Rate – CAGR for short – is a performance metric that provides investors with information about how much a property’s value grows from one year to the next. In other words, it “smooths” out year to year volatility.
CAGR can be calculated manually using a complex formula. Or, it is more commonly calculated using the “RRI” function in MS Excel.
There is no one CAGR that is considered to be “good.” Instead it is measured relative to an investor’s personal objectives and return requirements.
The CAGR is used to measure performance in all types of businesses, including commercial real estate. In this context, it is helpful when comparing investments, tracking their performance, or identifying a property’s strengths and weaknesses.
While the CAGR is a useful metric, investors should be aware of two important limitations. First, it does not take a property’s risk level into account. Second, it assumes a constant rate of growth over the holding period.
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