As a real estate professional, it’s important to understand the concepts of the internal rate of return (IRR) and capitalization rate (cap rate). You often hear these terms thrown around the table when discussing the merits of a property–that’s because IRR and cap rate are both used in assessing the value of a potential investment. In this article, we will explore two crucial concepts to investment real estate.
What is Capitalization Rate (Cap Rate) and How Is It Calculated?
The capitalization rate is a ratio of income to value – simple. However, there exist several versions for computing a property’s cap rate, depending on the exact numerator and denominator used. In the more popular formulas, the cap rate is calculated by dividing the Net Operating Income (NOI) by either the property’s purchase price or current market value, with the final number written in percentage form.
Using Purchase Price
The first formula looks like this: Net Operating Income/Purchase Price = Cap Rate
Using this formula, we give you an example of an investment property’s profitability:
Property A was purchased at $1 million dollars, and has an NOI of $100,000. That gives us a cap rate of 10%.
Using Current Market Value
Another formula often used to compute the cap rate is this: Net Operating Income/Current Market Value = Cap Rate
Example for this formula:
For Property B with a current market value of $500,000 and has an NOI of $25,000, the cap rate is 5%.
How to Interpret Cap Rate
The higher the cap rate, the more income you are “getting” for the price. In other words, you are buying a greater income stream. The lower the cap rate, the less income you receive for a given price. Risk, or the likelihood to obtain an income stream, would be a major factor influencing price. The higher the cap rate (typically) the greater risk. That said, the availability of capital will also greatly influence cap rates. More available capital (more investors looking for a deal) can bid up values and lower cap rates.
Now, let’s talk about one of the most important factors computing for the cap rate–the investment property’s Net Operating Income (NOI).
What is Net Operating Income?
The NOI is the property’s annual return, minus taxes and any operating costs such as maintenance and utilities. Note that capital improvement and depreciation expenses are not part of NOI, so you cannot include that in the computation.
NOI can be expressed in multiple ways:
- Current Month NOI Annualized
- Projected (Proforma) NOI
- NOI After Stabilization
- Trailing NOI
To get the most usefulness from analyzing cap rates, it is crucial that investors understand the assumed conditions that go into each expression of NOI.
The Pros of Using Cap Rates
- Most commonly used method to evaluate income producing property by real estate investors, real estate professionals, appraisers, and banks
- Considers operating costs within a property, making the cap rate more of an accurate reflection of the property’s performance
The Cons of Using Cap Rates
- Difficult to predict operating costs in the future, meaning that the likelihood of an accurate estimate is diminished
- Only accounts for a specific period of time (typically one year)
- Does not account for debt
Now, that we understand cap rates, let’s go over the internal rate of return (IRR).
What is the Internal Rate of Return (IRR)?
The IRR is a metric used to estimate an investment property’s potential performance. It is a dynamic measurement that looks at the investment’s value over the entire holding period by computing the rate at which the present value of cash flows is zero. In short, the Internal Rate of Return is the percentage earned on an investment during the set time frame in which it’s invested, assuming a reinvestment of cash flows.
How is the Internal Rate of Return (IRR) Calculated?
There is a formula for calculating the IRR, but computers now do all the heavy lifting. Here, you determine which discount rate makes the present value of the future after-tax cash flows equal to the initial cost of your capital investment. For simplicity’s sake, you are looking for the discount rate to get net present value (NPV) to $0.
The Pros of Using IRR
- Multi-dimensional approach; projects returns over the entire ownership period, giving a clear long-term view of both the risks and the returns
- Factors in returns from appreciation and operations
- Allows investors to compare performance of different properties
- Accounts for the economic concept of time value of money
- Adjusts for inflation, which means investors not only know how risky a particular property is, but how much it would be worth in the future
The Cons of Using IRR
- Does not account for the size of the project because cash flows are compared to capital output, which can paint an inaccurate picture if projects of two very different sizes are being compared
- For Example: Project A has $100,00 in capital output and a projected cash flow of $25,000 over the next five years. Using this formula, this brings the IRR to 7.94%. However, Project B has a capital output of $10,000 and projected cash flows of $3000 over the next five years. This brings the IRR to 15.2%.
- This example shows that the IRR makes the smaller project seem more attractive but ignores how the larger project could generate much higher cash flows and profits.
- Requires the estimation of an exit or reversion value
- Does not account for fluctuating reinvestment rates
When to Use Cap Rate and IRR
Cap rates are useful if you need a quick or rough estimate. They are also the better option when the property is a single-tenant one with a long-term lease. In this sort of situation, the income is likely to remain even and figuring out annual operating costs will be relatively straightforward.
However, if the property in question has multiple tenants and that changes every other month or so, then a monthly estimate becomes quite difficult to grasp with just the cap rate. In this scenario, the IRR will be far more accurate in predicting returns over the length of the investment.
Ultimately, the IRR is a more comprehensive approach to understanding your investment and making the right choices. Assuming you use the right assumptions, the calculations will be reliable. But both are tools to be used in context of a larger investment analysis.
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