CAP Rate, Cash on Cash Returns, IRR – What would you use to accurately evaluate the return on your investment?
Having a set of principles, procedures and tools that assist in interpreting financial data is important in itself. More important though is the ability to truly understand and construct them. This is what turns them from numbers on a page into an accurate model of a potential investment.
Investors use different metrics to compare one real estate investment opportunity against another. What is the right metric to use? CAP rates are a very popular way to quickly analyze the return on an investment but this CAP rate only represents a moment in time, that is, it tells you what the return on the investment will be based on that year’s projected net operating income without taking into account the impacts of financing.
For example; say you are buying a 10 unit multi-family property for $1,200,000. The net operating income is $60,000 yielding a CAP rate of 5.00%.
$90,000 NOI / $1,200,000 Purchase Price = CAP RATE of 7.5%
The Cash on Cash Return gets you one step closer towards getting a truer picture of what the return of investment will be to you personally. That is, the Cash on Cash
Return looks at the annual before tax cash flow left over after deducting any debt service against the property and the total cash invested. So depending on your loan to value ratio and the interest rate, the Cash on Cash return will be different for each investor.
The formula for calculating the Cash on Cash return is:
Annual Before Tax Cash Flow
Total Cash Invested
The $30,000 Annual Before Tax Cash Flow / $300,000 Equity = 10% cash on cash return which looks even more favorable than the 7.5% return demonstrated by using the CAP rate to determine the real return on the investment
Using the Cash on Cash return does have its limitations because it doesn’t take into account the other 9 years of operating cash flows in the holding period. It also ignores the reversion cash flow at the end of year 10 that comes from the sale of the asset.
The most accurate way to determine the long term return of an asset is by looking at the Internal Rate of Return (IRR) which not only accounts for financing but uses discounted cash flows and the reversion cash flow at the end of year 10 that comes from the sale of the asset. Most analysis models assume a ten year holding period and use a discounted cash flow rate. The IRR is as close as you can get to the real return on investment, this being said it is often the most useful in comparing to an expected or desired return and gauging attractiveness of different investment opportunities. A more thorough dialogue about the IRR metric will be coming in a future article.