When looking at a commercial real estate investment, a common question when trying to value a property is “What return metric do I need to use?” Common metrics include, Cap Rate, Cash on Cash and IRR. These metrics approximate a yearly percentage return you’ll receive on your property investment. Which return metric is best for your particular property? Let’s first look at how each metric is calculated.
The cap rate is a real estate industry term which is determined by dividing the net operating income of your property by the purchase price of your property. So, if you bought a property for one million dollars and in the first year your net operating income was one hundred thousand dollars, then your cap rate would be ten percent or you would say that you bought the property at a ten cap. Cap rates are also used to approximate the price you would pay for a building. Riskier investments require higher returns, so that a riskier property would require a higher cap rate from an investor. A safer property would be purchased at a lower cap.
Cash on cash is another industry term that is calculated by dividing the investor’s cash flow of a property during an operating year with the amount of cash the investor has invested. So, if an investor offered a hundred thousand dollars of equity to get a building and they received eight thousand dollars in income after all expenses and debt service during a certain operating year, then the investor’s cash on cash return in that operating year was eight percent. Another derivative of cash on cash is called cash on cost. Instead of the cash investment to purchase an income producing building, this metric uses the total cost for building or renovating a building along with the associated cash flows that the investment will generate.
IRR is a general finance term that is commonly used in commercial real estate. IRR stands for internal rate of return and is calculated by using all the cash flows an investor will make (positive and negative) over the course of the investment period. IRR represents the average annual yield the investor will realize over that time period.
What are the differences between these return metrics? Cap Rates are usually used in analyzing the purchase and sale of properties. They only look at the transaction event in that specific time period and do not look at the entire string of cash flows. Cap Rate is a good way to get a quick judge of how a particular property is being valued. Cash on cash looks at the individual cash flow periods and does not look at appreciation of the asset upon exit. IRR looks at the entire cash flow of the investor and is a more exact approach to valuing an investment.
For more advice on creating real estate pro formas and excel templates, please see the Pro Forma GURU: Guide for Real Estate Investing at www.ProFormaGURU.com
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