Master CAP rate vs IRR for maximized profits

If you are looking at buying or investing in a commercial real estate project, you will probably hear about cap rates and IRR.

In my multi-family days, my husband and I used both. We would look at cap rates as part of the initial broker marketing document and only at properties that met our criteria. And then, as we got deeper into due diligence info, we’d put together an IRR.

Join me in this super insightful blog post, where I’ll discuss cap rate vs. IRR. Together, we’ll gain a solid grasp of these fundamental concepts. Let’s go!

TL;DR:

• Cap rates and IRR help us understand potential returns, but they look at things differently.
• Cap rates rely on past information like net operating income and purchase price.
• IRR tries to predict future earnings by considering expected rent increases and changes in property value.

The Basics of Cap Rates and IRR

Cap rates determine potential returns in real estate investing. To calculate the cap rate, divide the property’s net operating income by its current market value.

Higher cap rates indicate greater returns but with increased risks. Lower cap rates suggest lower risks and returns.

When my husband and I were in multi-family, we wouldn’t even look at a property if it had a cap rate of less than 8%….. times have changed! You would be hard-pressed to find a property in today’s market at that rate.

IRR (Internal Rate of Return) measures profitability over time. This calculation uses categories like rental income, expenses, and value appreciation. IRR calculates the annual yield, accounting for cash inflows and outflows throughout the investment’s life. 

A higher IRR suggests a more profitable investment, while a lower IRR indicates a less attractive opportunity. Understanding IRR helps you determine potential profitability, assess risks and rewards, and make investment decisions in real estate.

Fundamental Concepts Behind These Metrics

The fundamental concepts behind metrics like IRR and cap rates are to assess an investment’s potential profitability and value.

Calculating IRR

While cap rates provide a static view of investment returns, the IRR offers a more dynamic perspective. IRR considers the timing and magnitude of future cash flows, including the resale price. This makes it particularly valuable when assessing properties with different rental incomes or various exit strategies.

I vividly recall devoting countless hours to meticulously analyzing spreadsheet data when investing in multi-family commercial properties. We would meticulously fine-tune variables such as rent increases and expense reductions to project the internal rate of return (IRR).

In addition to future rent projections and operational cost improvements, the eventual sale proceeds are part of the IRR calculation.

The final step in the calculation is to discount the projected earnings back to present value using an assumed interest rate. This figure is the projected IRR, which captures the full performance expectations throughout the investment’s lifecycle.

Calculating Cap Rates

The broker often lists cap rates on the initial marketing details on a property. Take multi-family as an example. You’ll see the number of units, the purchase price, the cap rate. These sheets include recent improvements, opportunities to add value, and the occupied (rented) property percentage.

My husband and I always joke about how the properties for sale are always fully occupied. Sure, it doesn’t mean they have qualified tenants, but at least they’re fully occupied! 😁😁😁

Let’s break down cap rates step by step:

Understanding the Cap Rate Formula

Calculating a property’s cap rate is simple. It involves Net Operating Income (NOI) and the property’s current market value. Here’s how you calculate it:

This formula estimates the return on investment you can expect from a property without considering finance charges. Higher cap rates mean higher potential returns but also greater risk. So be cautious.

Now, let’s put theory into practice:

Imagine a commercial building costs $1 million. After operational expenses, it generates an annual NOI of $75k.

Using our formula:

Cap Rate = $75,000 / $1,000,000

This gives us a cap rate of around 7.5% per year, assuming no changes in income or expenses.

The cap rate doesn’t consider future expenses or mortgage financing so you should use it alongside other tools like IRR calculations when comparing investments.

Unpacking IRR

IRR looks ahead and predicts how your investment might perform in the future.

Calculating IRR helps you understand the total returns you can expect each year if you plan to change your property or renovate it later.

The Process of Calculating IRR

To determine the IRR, calculate future cash flows from rent or resale and then find a discount rate that balances the value of money over time. Here’s how to get started:

✔First, write down all the money you expect to receive and spend throughout your investment’s life. This includes the cost of buying, renovating (if needed), and maintaining the property.

✔Also, consider expected rent increases and property value changes. This detailed list forms the basis for calculating IRR using spreadsheet software or online tool. It’s important to think about every factor that affects the equation. 

This includes understanding local market trends that impact rent prices and assessing the building’s condition and age for potential repairs. By doing this, you can make realistic estimates of both income and expenses. This helps you determine how well the investment will perform overall.

Comparing Cap Rate vs IRR

Cap rates and IRR help us understand potential returns, but they look at things differently. One big difference is how they use data. Cap rates rely on past information like net operating income and purchase price.

On the other hand, IRR tries to predict future earnings by considering things like expected rent increases and changes in property value.

When to Use Cap Rate vs. IRR

Deciding between cap rate and IRR depends on your investment strategy and goals. If you want a quick and easy way to see how much income a property can generate right now, cap rate is the way to go. It gives a snapshot of the property’s return based on its income and purchase price. 

However, the cap rate doesn’t consider changes that might happen in the future, like market ups and downs. On the other hand, if you’re planning to make improvements to the property and sell it later, IRR is a better choice. 

IRR considers projected future earnings and potential changes in the property’s value. It gives you a more complete picture than cap rate, which is a simple and fixed measure.

My recommendation is to use both. First, look at the cap rate to filter properties for further investigation. Once you decide on properties from this list and you have access to the due diligence information, you can calculate the IRR.

Limitations of Cap Rates and IRR

When evaluating investment opportunities, be aware of limitations associated with using cap rates and internal rate of return (IRR) as financial metrics. Neither metric provides a complete picture, so I recommend using both.

Constraints in Using Cap Rates

Using cap rates alone has a big downside. It doesn’t take into account mortgage financing or future expenses. This means a property might look good with a high cap rate, but things can change if you don’t consider renovation costs or how income might go up and down over time. 

Another limitation of cap rates is that they only show information based on current income and value. They don’t think about how the market could affect these numbers in the future. Investors should keep this in mind when calculating returns using just cap rates.

Pitfalls Associated With IRR Calculations

Next, we’ll look at the difficulties that come with calculating IRR. One big problem is relying on projected cash flows based on assumptions about future earnings and resale prices. If you’re too optimistic, it can give you higher results that don’t match reality. 

This reliance makes predicting growth hard, especially if you lack experience in specific markets. Small mistakes can lead to big miscalculations. Plus, handling multiple amounts of money coming in and going out during the investment’s lifespan requires advanced financial modeling skills, which is more complicated than using simpler metrics like cap rates.

Deciphering Good from Bad – Higher vs. Lower Returns

Knowing what makes a good real estate investment means understanding if a higher internal rate of return (IRR) is better than a lower one and how cap rates come into play. 

A high IRR usually means the investment has the potential for big profits over time. It shows that much future money will come, which is attractive to long-term investors. 

An example is the IRR for the hotel we bought in 2019, which included estimates of economic growth in the area where it is located.

Here’s the thing… the IRR model 2019 had no clue about the wild ride COVID had in store for hotels in 2020. 😲

But a low IRR doesn’t automatically mean it’s a bad investment. To understand these numbers, you need to consider the context. 

Two properties might have similar risks, but one has a higher IRR, making it more appealing to investors. This is why doing your research is so important in real estate investing.

Navigating Capitalization Rates

Interestingly, cap rates can tell similar stories to IRRs, but there are some differences to consider. A property with a high cap rate usually means that, compared to its purchase price, it can generate a lot of income immediately. This can make it a good choice for certain investors. 

However, a high cap rate can also indicate risks associated with the property, like problems with the location, the need for significant maintenance, or, as I mentioned earlier… tenant turnover. These things can affect your income and lower your actual returns over time. Learn more about capitalization rates here.

Tackling Highs and Lows Effectively

To make smart decisions in real estate, you need to understand market trends and have detailed information about each property, like the potential for growth in the neighborhood.

Looking at high or low values doesn’t tell you if it’s a good or bad investment. They’re just clues that help you dig deeper and consider all the important factors before deciding.

Practical Application – Real Estate Examples

In commercial real estate, cap rates and IRR are important tools investors use to make smart decisions. Let’s explore two recent transactions and how these numbers are used in practice.

Example 1: Apartment Complex Acquisition

An experienced investor decided to buy an apartment complex for $10 million. The complex brings in $700,000 of income each year after expenses. To calculate the property’s cap rate, you divide the income by the property’s value. 

The result? A nice 7% ($700k/$10M).

This tells us that if everything stays the same and no additional costs are considered, it would take about fourteen years to earn back the initial investment. This is helpful information to understand the potential future earnings.

Example 2: Office Building Development Project

A group of investors decided to develop an office building. They expected to earn half a million dollars yearly for five years and then sell the building for twelve million dollars. To determine the projected IRR for this project, they needed to know the total cost, including development expenses, which added to about eight million dollars. 

Calculating the IRR involves finding a rate, denoted as “r,” where the Net Present Value (NPV) equals zero. This is done by considering the future cash flows for each year, discounted back to their present value, and subtracting the initial investment.

For this project, they considered all the years until the fifth year when they plan to sell the building at the expected resale price. 

The result? An impressive internal rate shows the average annual return they can expect from this project, considering the discounted value of future cash flows compared to the initial investment.

This is a great example of how IRR calculations can help us understand our returns on investment.

Conclusion

Now you grasp cap rate vs. IRR; you are well-equipped to evaluate commercial real estate projects.

We have walked through calculating both metrics, providing insights on how they can inform your investment decisions. Additionally, you now understand to start with cap rates and then calculate IRR during the due diligence period.

Remember that these metrics have limitations; no single metric can paint a complete picture. A higher return isn’t always better; it depends on your risk tolerance and financial goals. Happy investing!

FAQs About Cap Rate vs. IRR

What is the relationship between IRR and cap rate?

IRR and cap rate are metrics commonly used in real estate investing, with distinct purposes. Cap rate evaluates a property’s present value based on income, whereas IRR considers the potential for future returns.

Is a 30% IRR good?

A 30% Internal Rate of Return (IRR) is considered excellent for most investments. However, remember that high return often comes with increased risk.

Is ROI more important than cap rate?

The importance varies depending on investment goals. ROI measures total return, including appreciation over time, which is useful for long-term investments. Cap rates evaluate immediate profitability from rental income, which is beneficial for short-term or buy-and-hold strategies.

What is Cash On Cash Return?

Cash on cash return measures the annual return an investor earns on a property relative to the amount of mortgage paid during the same year.

Is a capitalization cap rate the same as an IRR?

No, cap rates and IRR aren’t identical. They have different calculations with distinct inputs. IRR tends to be higher because it factors in projected future cash flows.  Knowing the difference between cap rate vs IRR will help you decide on real estate investment projects.