Where Does the Return Actually Come From?

Whenever I look at an investment opportunity, I like to strip the projected return back to one very simple question:

What actually has to happen in the real world for this return to be earned?

A projected 12%, 15% or 20% return is an output. It is not an investment thesis. The investment thesis is the economic engine underneath that number — and understanding that engine is one of the most useful ways I know to evaluate an opportunity.

Every return has a source

Consider a private business. An investor might make money because:

• revenue grows;
• profit margins improve;
• debt is paid down;
• the business generates cash that can be distributed;
• acquisitions increase the company's earnings;
• or a future buyer is willing to pay a higher valuation multiple.

Those are very different sources of return. Academic research examining leveraged buyouts has similarly separated private-equity value creation into factors such as operating performance, leverage or debt reduction, and changes in valuation multiples. The relative contribution varies considerably from transaction to transaction.

Now consider real estate. The return may come from:

• rental income;
• increases in net operating income;
• debt amortization;
• renovations or repositioning;
• development;
• changes in market value;
• or changes in capitalization rates.

The institutional real-estate industry literally separates total return into income return and appreciation return. NCREIF, for example, reported a 1.29% total return for its Property Index in the second quarter of 2026, consisting of a 1.17% income return and a 0.12% appreciation return. That is not a forecast — it simply illustrates that total return can be decomposed into different economic components.

Private credit is different again. There, the primary return engine may be interest paid by the borrower, origination or other fees, principal repayment and, depending on the investment, some equity participation.

Same word — “return.” Completely different engine.

Some return assumptions require more faith than others

This is where underwriting becomes interesting.

Imagine two investments both projecting the same return. Investment A expects most of its return from cash generated by an operating business over five years. Investment B assumes the asset can be sold in five years at a much higher valuation multiple.

The headline return may look identical. The assumptions underneath it are not. Investment B may depend far more heavily on future market conditions that neither the investor nor the operator can control. That does not make it a bad investment. It simply means the investor should understand what has to go right.

The same applies in real estate. If the investment works because rent grows modestly while debt is reduced and cash flow is generated, that is one thesis. If it works primarily because the property is expected to sell at a dramatically lower cap rate in five years, that is another. Neither is automatically right or wrong. But they deserve different levels of scrutiny.

Leverage can enhance a return without creating the underlying economics

Debt deserves special attention because it can magnify equity returns. If an asset increases in value while part of the purchase price was financed with debt, the gain relative to the investor's equity can be substantial.

But leverage works in both directions. It magnifies losses as well as gains, introduces interest expense and creates obligations that must be met regardless of whether the investment performs as expected.

That is why I separate two questions:

• Is the asset itself performing well?
• Is the equity return high because the asset is performing well — or because the capital structure is highly leveraged?

Those are not the same thing.

IRR is not the business model

Another mistake I see is allowing an IRR projection to dominate the conversation. IRR can be useful, particularly when comparing investments with different timing of cash flows. But the number alone does not tell me enough. I want to know:

• What percentage of the projected return comes from operating cash flow?
• How much comes from growth?
• How much comes from paying down debt?
• How much depends on selling the asset for more than was paid for it?
• And what happens to the return if the exit takes two years longer than expected?

That last question is especially important because private investments rarely unfold exactly according to the original spreadsheet.

Start with the economic engine

Before debating whether an opportunity offers a “good return,” I think investors should first be able to complete this sentence: “I make money in this investment if…”

If the answer is clear, measurable and economically sensible, you can begin evaluating the assumptions. If the answer requires five minutes of explanation and three pages of financial projections, I usually want to keep digging.

A return projection should ultimately be traceable to something happening in the real economy:

• A tenant paying rent.
• A borrower paying interest.
• A company earning more money.
• A property becoming more productive.
• Debt being repaid.
• Or another buyer placing a higher value on the asset.

Once you understand which of those engines you are depending on, the return number becomes much more meaningful.