Understanding Cap Rate, IRR, and Cash on Cash Return: A Comparison for Real Estate Investors
When evaluating real estate investments, there are several key metrics investors use to gauge profitability and potential returns. Among the most commonly used, and highly debated, are Cap Rate, IRR (Internal Rate of Return), and Cash on Cash Return. Each of these metrics offers a different perspective on the investment’s performance, and understanding the distinctions between them is essential for making informed decisions.
In this post, we’ll break down what each of these terms’ means, how they’re calculated, and how they can help you assess an investment.
What is Cap Rate?
Cap Rate, or Capitalization Rate, is a simple metric that provides a snapshot of an investment’s potential return based on its annual net operating income (NOI). It’s often used to compare different properties or investment opportunities within a similar market.
Formula:
Cap Rate=Net Operating Income (NOI)Property Value×100Cap Rate=Property ValueNet Operating Income (NOI)×100
Where:
- Net Operating Income (NOI) is the annual income generated by the property after operating expenses but before debt service (mortgage payments).
- Property Value is the market value or purchase price of the property.
Pros of Using Cap Rate:
- Simplicity: It’s easy to calculate and doesn’t require detailed cash flow projections.
- Quick Comparison: Cap Rate helps investors quickly compare the relative returns of different properties.
- Market Perspective: It can provide insight into how the property stacks up against the broader market or similar properties.
Cons of Using Cap Rate:
- Doesn’t Account for Financing: Cap Rate is calculated without considering mortgage payments or financing, so it doesn’t give a full picture of the investor’s cash flow after debt.
- Ignores Future Appreciation or Depreciation: Cap Rate is a static number and doesn’t consider the potential for future changes in property value.
Example:
If a property has a Net Operating Income (NOI) of $50,000 and is valued at $1,000,000, the Cap Rate would be:
Cap Rate=50,000 1,000,000×100=5% Cap Rate=1,000,000 50,000×100=5%
What is IRR?
IRR (Internal Rate of Return) is a more comprehensive metric that reflects the profitability of an investment over time, factoring in the time value of money. It is the discount rate that makes the Net Present Value (NPV) of all cash flows from the investment equal to zero. Essentially, it represents the annualized effective compounded return that an investor can expect to earn from an investment.
Formula:
The formula for IRR is complex, as it involves solving for the discount rate that equates the present value of cash inflows and outflows. Most investors calculate IRR using financial software or spreadsheets like Excel or financial calculators like the HP 12c.
0=∑(Ct(1+IRR)t)0=∑((1+IRR)tCt)
Where:
- C_t = Cash flow in period t
- t = Time period (usually years)
Pros of Using IRR:
- Time Value of Money: IRR accounts for the timing of cash flows, making it a more accurate representation of long-term profitability.
- Comprehensive: It considers both initial investment, operating cash flows, and eventual sale or refinance of the property.
- Investment Comparison: IRR allows for the comparison of projects with different cash flow profiles and timeframes.
Cons of Using IRR:
- Complex Calculation: IRR requires more detailed forecasting and calculations.
- Multiple IRRs: In certain scenarios with unconventional cash flows (e.g., negative cash flows followed by large positive ones), multiple IRRs can exist, complicating the decision-making process.
Example:
If you invest $100,000 in a property and expect to receive $25,000 annually for five years, with an expected sale price of $150,000 at the end of year 5, the IRR would be the discount rate that makes the present value of these cash flows equal to $100,000.
What is Cash on Cash Return?
Cash on Cash Return (CoC) measures the annual return on the actual cash invested in the property. It only considers the cash flow received by the investor in relation to the initial cash investment, not including any financing or debt.
Formula:
Cash on Cash Return=Annual Pre-Tax Cash FlowTotal Cash Invested×100Cash on Cash Return=Total Cash InvestedAnnual Pre-Tax Cash Flow×100
Where:
- Annual Pre-Tax Cash Flow is the net income received from the property after operating expenses and mortgage payments.
- Total Cash Invested is the amount of money the investor personally puts into the deal, including the down payment and any other out-of-pocket costs.
Pros of Using Cash on Cash Return:
- Clear Cash Flow Focus: CoC provides an immediate view of how much cash income an investor is generating relative to their initial outlay.
- Simple to Calculate: It’s straightforward and doesn’t require complex assumptions or future predictions.
Cons of Using Cash on Cash Return:
- Ignores Long-Term Appreciation: CoC focuses only on annual cash flow and ignores potential property value appreciation or capital gains.
- Debt Impact: Since CoC considers debt service, it can be heavily influenced by the level of financing, which might not give a true representation of the property’s overall return potential.
Example:
If you invest $100,000 in a property and after all expenses, including debt service, you receive $12,000 in annual cash flow, your CoC would be:
Cash on Cash Return=12,000/100,000×100=12%
Comparing Cap Rate, IRR, and Cash on Cash Return
1. Scope and Timeframe
- Cap Rate: A snapshot metric focused on annual income relative to property value, with no time consideration.
- IRR: A long-term, dynamic metric that factors in the time value of money and accounts for cash flows over the life of the investment.
- Cash on Cash Return: A short-term metric that shows the immediate return on the cash invested, typically on an annual basis.
2. Use Case
- Cap Rate: Best for quick comparisons of property yields in a given market or assessing how a property is performing relative to its price.
- IRR: Ideal for evaluating long-term investments with complex cash flows or comparing projects with different timeframes.
- Cash on Cash Return: Useful for investors who want to focus on the immediate, tangible returns on their actual invested capital, especially when considering rental properties with financing.
3. Consideration of Debt and Financing
- Cap Rate: Doesn’t account for financing, which means it can be misleading if leveraged heavily.
- IRR: Includes financing considerations and is affected by the capital structure, but it also accounts for the time value of money.
- Cash on Cash Return: Directly reflects how much the investor receives after financing costs, making it especially useful for debt-driven investments.
Conclusion
Each metric—Cap Rate, IRR, and Cash on Cash Return—has its place in real estate investment analysis, and none is universally superior. Cap Rate is great for initial evaluations and comparisons across different properties. IRR provides a more comprehensive, long-term view, accounting for the timing and risk of cash flows. Cash on Cash Return focuses on the immediate cash flow relative to your cash investment, making it useful for investors who prioritize regular income.
As an investor, it’s essential to use all these metrics in combination to get a full picture of the investment’s potential. While one metric might highlight a certain strength, together they offer a clearer, more nuanced understanding of your investment’s return profile.
The Basic Real Estate Investors Blog 
Leave a comment