Cap Rate vs IRR

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January 31, 2023

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When investing in the midwest / Cincinnati Northern Kentucky area, IRR and cap rate are two of the most common metrics used by real estate investors to determine if the risks and benefits involved in an investment are worth it. In this article, we will be comparing cap rate vs IRR.

Cap Rate vs IRR General Overview

Before going through a commercial real estate investment, investors need to evaluate the risks and benefits of such investments. Although this is a challenging task, metrics such as IRR and cap rate have been devised to simplify the process and offer a better understanding of the value of a property.

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Cap Rate

Capitalization rate is a metric used to calculate the potential returns on a commercial property. It is represented as a percentage that varies depending on the standard of the property, its asset class, and other factors.  You can derive a property’s capitalization rate by dividing the Net Operating Income (NOI) by the cost of purchasing the property.

For instance, if a property costs $5 million to acquire and generates a $250,000 annual net income, the property will have a 5% capitalization rate. Being inversely proportional to property value, capitalization rates will decrease if the value of the property increases and vice versa. These rates can also be used to calculate a property’s value.

However, capitalization rate calculations do not include debts, as it operates on the assumption that a property is acquired without leverage. This is because the cost of commercial loans depends on factors like the amount of equity in the transaction, the investors’ portfolio, and experience, all of which can ruin the numbers for certain investors. 

Internal Rate of Return (IRR)

Internal Rate of Return (IRR) is a metric that conveys an estimate of the total returns on investment that will be realized over the holding period of an investment property while putting into consideration:

  • Value of the property
  • Debt service 
  • Changes in income. 

IRR provides a yearly analysis of the total returns on a real estate investment. Since IRR is a concept that considers the time value of money and the rate of return throughout the life of an investment, calculations are usually complicated. To calculate IRR, you must identify the annual cash flow from the property and how much will be realized from each of them. These cash flows include:

  • Cash flow from rent
  • Cash flow from the sale of the property
Data graph on a laptop

In general, the IRR is a means for investors to disregard income realized in the future based on inflation. The earlier the revenue from an investment is received, the higher the IRR. IRR calculations don’t consider variables that alter all-around returns on investment. Therefore, a higher IRR doesn’t make one investment better than another.

Comparing Cap Rate and IRR

To understand cap rates and IRR, you must know the similarities and differences between them. 

Similarities Between Cap Rate and IRR

Here are the similarities between both metrics:

Role in Evaluating Investment Performance

As stated earlier, both metrics are ROI measures that real estate investors use when evaluating a potential investment’s overall risks and benefits. Though there are many tools at the disposal of investors, these two metrics are more frequently used than others. Results from these metrics aid investors in making better investment choices.

Both metrics are related to a property’s resale price. When determining the IRR on an investment property, the resale price is an essential factor. This is because the resale price is the largest one-time income an investor will realize from a property. Also, the capitalization rate at the time of the property sale influences the property’s IRR.

“Garbage In Garbage Out”

When it comes to making both metrics meaningful, both metrics share a common shortcoming- the results from the calculations are as good as the data you provide. Although they are devised to evaluate investment performance, your estimates will be wrong if your future projections are bad. 

Therefore, it is important for you as an investor to carefully analyze all necessary data to avoid misleading results. To this end, it is advisable to work with brokers, such as Si Vales Valeo Real Estate, who conduct professional CRE analyses and calculations based on valid data and variables to generate accurate results that aid investors in evaluating and comparing potential investments.

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Major Distinguishing Factor Between Cap Rate and IRR

The major distinguishing factor between these two metrics is that cap rates only provide real estate investors with an estimate of potential returns on investment for a single period during the existence of the real estate investment. On the other hand, IRR calculations convey an annualized overview of the potential returns realized from an investment in real estate.

When to Use Cap Rate

As a tool for evaluating investment opportunities, this metric can be used when real estate investors want to compare investment risks to benefits. Properties with higher capitalization rates provide higher investment risks and vice versa. However, determining if a property with a higher or lower rate is better depends on the investor’s portfolio. 

When to Use IRR

Internal Rate of Revenue is used when analyzing the period of a real estate investment and is efficient for short-term, medium-term, and fixed periods with a projected exit strategy. Although it might be efficient for small projects like single to three-family home investments, the IRR metric is perfect for large projects where investors expect repayment after a specified period.

Which Is Better?

Considering that both metrics provide investors with results that aid them in making intelligent investment decisions, it wouldn’t be reasonable to say that one is better than the other. Although the IRR includes the cost of capital, as you can calculate with or without leverage, there are situations when you need cap rates to make proper decisions.

In other words, investors can determine which metrics will provide them with the appropriate information depending on the situation.

Final Verdict

Both are essential metrics for evaluating the risks, benefits, and expected returns on property investments in the midwest / Cincinnati, Northern Kentucky area. However, it is advised that you seek assistance from professionals like Si Vales Valeo Real Estate for accurate results that will positively impact your investment decisions.

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