IRR vs Cap Rate: Key Real Estate Indicators
September 13, 2022
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Investors have many metrics to consider when evaluating properties. For example, IRR vs cap rate is a common debate. Both can help you get the bigger picture, but neither should be used alone.
The capitalization rate, or cap rate, measures the potential return on investment but does not consider the mortgage. The IRR measures your expected returns over the investment timeline.
Here's the most important information about the cap rate and IRR.
What Is a Cap Rate?
Cap rates help investors determine the potential return on a real estate investment property. It's often a good way for real estate investors to compare potential properties and how much risk each entails. The cap rate is a snapshot of the returns a property should provide given its current net operating income and property value.
It helps prospective investors determine each property's risk and allows them to compare investment opportunities. The cap rate also helps investors understand how long it will take to earn enough profit to cover the cash invested.
When to Use or Not Use
Investors get the most information from cap rates when used on commercial real estate properties. It's a good way to compare your options when considering several properties.
However, you should only use the cap rate calculation on properties with consistent income and properties you plan to keep long-term. For example, it isn't a good metric for fix and flip properties or even single-family properties. Instead, you should reserve the cap rate for multifamily properties, apartment complexes, office buildings, and strip malls.
Cap Rate Formula
To calculate cap rates, you'll need the property's net operating income and the property value or asking price.
The NOI is the total of a property's income streams minus its liabilities. However, the NOI is a property's net income, so it doesn't include a property's mortgage. In net operating income, you should include all income streams, such as rental income, income from amenities (such as on-site laundry machines), and any other fees you charge. The expenses included insurance, taxes, repairs, the average vacancy rate, and legal costs.
Typically, investors use the property value to calculate the cap rate; however, the purchase price may be a better fit in some instances.
How a Cap Rate Is Calculated
To calculate the cap rate, use the following formula:
Cap rate = Net operating income/Property value
Multiply the answer by 100, and you have your cap rate percentage.
What Is a Good Cap Rate?
Like most metrics, a good cap rate is subjective. Investors use cap rates to determine if it fits within their comfort level. As a result, properties with a higher cap rate often have a better annual return on the money invested.
What a Higher Cap Rate Means
Properties with higher cap rates are usually riskier than properties with a lower cap rate. A lower cap rate also means it may take longer to recoup the cash flows you invested in the real estate investment. In addition, a higher cap or higher risk often means a higher potential return (as well as a larger loss).
Example in Real Estate
Here's an example of how cap rates can help you assess an investment opportunity.
Joe has his eye on three real estate investment properties. He knows each property's annual income, expenses, and market value, so he calculates the cap rate as follows:
- Property A - Income $150,000, expenses $6,500, and property value $1.2 million
- Property B - Income $225,000, expenses $13,000 and property value $3.8 million
- Property C - Income $125,000, expenses $4,800, and property value $1.3 million
The cap rates are as follows:
- Property A - 11.9%
- Property B - 5.6%
- Property C - 9.2%
Joe can use these percentages to determine what he's comfortable with while also looking at the property's other metrics. For example, he'll likely exclude property A because it's a riskier investment and focus on Property B or C.
What Is IRR?
The IRR or internal rate of return is another metric to compare real estate properties. It's a more complicated calculation, but it helps you understand what you might make over the holding period. The IRR considers the changes a property can undergo, including increasing or decreasing income and property service. It also considers the debt service required to acquire the property.
The IRR provides a property's total returns on an annualized basis. Keep in mind, though, that the IRR can change each year. In other words, the IRR is a picture of a property's future cash flows and includes the money earned by selling the property.
When to Use or Not Use
The IRR calculation gives investors a bigger picture of a property's potential than the cap rate. This is because it includes all profits and expenses (mortgage too). As a result, you can use IRR calculations to compare real estate properties and non-real estate investments.
You shouldn't rely only on the IRR like any metric. It's a measure of the net present value of investment opportunities with assumptions of what might happen in the future. Since no one can predict the future, it shouldn't be the only metric used.
Calculating IRR is more complicated than the cap rate since it considers the time value of money. In other words, future earnings are worth less than they would be today because of inflation and other economic factors.
To calculate IRR, you must know the property's annual cash flows. You can use either projected cash flows or past cash flow earned. Remember, the cash flows include the rental income earned and any profits from selling the property.
How IRR Is Calculated
To calculate IRR, you must know the initial investment required, the rental income predicted for the holding period, and the projected exit strategy, aka purchase price.
It's best to use the formula in Excel or a financial calculator to calculate, as it will bring back flashbacks from high school calculus. Make it easy on yourself, and use a spreadsheet or calculator to do it for you.
The calculation considers the future cash flows and their net present value to help you compare investment opportunities.
What Is a Good IRR?
Like most financial metrics, a good IRR is subjective. For example, some conservative investors want IRRs around 10%, whereas others willing to take a chance want IRRs around 20%.
What a Higher IRR Means
A higher IRR doesn't necessarily mean it's a better investment. Here are a few scenarios to consider.
You might invest in an older home in an area with high appreciation rates, which may show a higher IRR. However, older homes often need more maintenance, decreasing your cash flow. If demand in the area also decreases, you could lose money versus making it, despite the higher IRR.
However, a newer home may have a lower IRR because new homes appreciate slower, which means a lower profit and less risk.
Example in Real Estate
When looking at IRR, it's important to look at the big picture. Just the IRR isn't enough. Take, for example, the following two properties.
In the first property, you invest $250,000 and expect $62,500 per year in income. The second property requires $150,000 upfront and brings in $37,500 a year.
The IRR would be the same for each property; however, the cash flow from the second property is half of the first property's cash flow.
Cap Rate vs IRR: Key Differences
The largest difference between cap rate vs IRR is the use of debt service. For example, you can calculate the IRR with or without a mortgage, but the cap rate never includes the mortgage.
The cap rate is best for a single-family property with a long-term lease. Since the income won't change, and you can quickly determine the annual operating expenses, it's easy to determine.
Is It Better to Use IRR vs Cap Rate for Analyzing a Property?
The IRR is best for investors who know the investment lifecycle and have an exit strategy. If you have a fixed period in mind, you can tell which investment would provide the rate of return IRR you prefer.
Cap rates are a good initial metric when comparing properties, but it doesn't consider the debt service, which can make a large difference in your decision.
Limitations and Factors Affecting Cap Rate vs IRR
The largest downside of the cap rate is that it doesn't consider any mortgage financing. The cap rate also relies on past income information, which, as we've seen in recent years, can change drastically, giving you inaccurate information.
The future income can be inflated for IRR calculations, which may throw off an IRR. The IRR formula also doesn't consider future expenses, which are bound to increase, which can throw off your calculations.
Check out these common frequently asked questions.
What Does a 15%, 18%, 20%, or 30% IRR Mean?
The internal rate of return tells investors how much they can expect to earn over the life of the investment. It's another metric to determine if an investment property is a good option. The higher the IRR, such as 30%, the riskier the investment will be.
What Is a Good IRR for a Rental Property?
A good IRR is subjective. Some investors prefer lower IRRs to take less risk, while others won't accept an IRR of less than 20%.
Why Is IRR Higher Than Cap Rate?
IRR considers the big picture, including all expenses incurred in a rental property. However, the property's cap rate doesn't consider the debt service, so it's not as high as the IRR.
What Is a Good IRR for Multifamily
Most investors prefer an IRR of 12% - 15% on multifamily homes. However, the outcome depends on how long you keep the property. The less time you own it, the higher your IRR will be because every dollar today is worth more than tomorrow.
Does a Higher IRR Mean Higher Return?
A higher IRR doesn't necessarily mean a higher return. You must factor in the risks involved too. In fact, a higher IRR often means you may earn less because there is a higher risk of loss but greater reward if everything goes as planned.
Is Cap Rate the Same as IRR?
The cap rate tells an investor the return on the investment he should expect. The IRR, on the other hand, shows the potential return over the entire holding period.
Do You Want to Sell at a High or Low IRR?
A higher IRR may forecast future cash flows will increase throughout the holding period. This can be a lucrative way to get more buyers. However, a lower IRR may appeal to more conservative investors, depending on your target market.
Does IRR Use Discounted Cash Flows?
Yes, the IRR calculation discounts cash flows to get the net present value, so you understand the property's full value.
You have many factors to consider when looking at IRR vs cap rate. Both calculations give you insight into a property's potential, but like any metric, they have flaws.
Look at both a property's potential and if an investment property is right for you. Learn more by signing up and visiting our blog.
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