“Cap rate” and “IRR” are two commonly used metrics that investors use to evaluate commercial real estate investments. They are metrics that many lenders will use, too, when underwriting a deal prior to making a loan on commercial property.
In today’s article, we look at the difference between cap rates and IRR, how each is calculated, and when to use which to evaluate a multifamily deal.
What Are Cap Rates?
Simply stated, a cap rate (technically, “capitalization rate”) is a formula used to estimate the potential return an investor will make on a property. Knowing a property’s cap rate is one way for investors to compare opportunities.
The cap rate is expressed as a percentage that varies according to asset class, quality of the asset, stage of the cycle we are in, and other factors, and have an inverse relationship to property value – the higher the value, the lower the cap rate, and vice versa.
How to Calculate Cap Rates
The cap rate for a building is derived by dividing the net income (unlevered) by the price or total cost of the building.
Cap Rate = Net Operating Income (NOI) / Property Value or Cost
The net operating income (NOI) is usually the actual NOI for the property over a one-year period. The property value is typically the seller’s asking price for the property, or the purchase price the investor is expecting to pay for the property.
For example, a building with $500,000 of net income that cost $10 million to purchase will be said to have a 5% cap rate.
Cap rates can be used to calculate the value of a building. For example, if in a particular geographical area, apartment buildings of the same age and caliber are selling for 5 caps, then a building with $1 million of net operating income will be valued at $20 million.
Note, however, that debt is not part of the cap rate calculation. Cap rates assume a property is purchased without leverage. This is because the cost of debt can vary depending on the investor’s profile, experience, amount of equity in the deal, etc., and therefore, including the cost of debt could skew the numbers for those looking to make an apples-to-apples comparison from one deal to another.
What is IRR?
An internal rate of return (IRR) is another way to value an investment opportunity. The IRR attempts to express what someone will make on an investment over the duration hold period, taking into consideration potential changes in income, property value, and debt service. IRR expresses total returns on a project, though they may vary from year to year, on an annualized basis.
In short, IRR is a value that describes the sum of all future cash flows according to when they occur in time. The sooner the same earnings from an investment are received, the higher the IRR.
How is IRR Calculated?
Calculating IRR is somewhat complicated. It is an abstract topic that considers the time value of money and the rate of return the investment provides over the entire life of an investment. According to the basic time-value of money principle, a dollar received today is worth more than a dollar received in the future given inflation. The IRR is essentially a way to discount earnings received in the future. The further in the future earnings are, the less valuable they become.
Therefore, in order to determine IRR, you first need the yearly cash flows the investment property is projecting to produce or has produced. The cash flows include both: (1) cash flow from rent; and (2) proceeds from the sale of the property. You must know how much cash flow is coming from each for the IRR calculation.
The challenge with calculating IRR is that even the most sophisticated investors can struggle to forecast future cash flows and sales proceeds. As such, more conservative investors will only use actual numbers to calculate a realized IRR instead of forecasted.
A few other things to note about IRR:
- The sooner the same earnings from an investment are received, the higher the IRR.
- Therefore, a project with a higher IRR does not necessarily mean it’s a “better” investment than something else. A higher IRR could translate into the same cash flow received but at an earlier point in time. A project with a lower IRR could have better returns but those returns are generated later in time.
- IRR calculations do not take into consideration the risk profile of a project or other variables that could potentially impact overall returns.
Why is IRR Important?
IRR is an important metric in that it can be used to supplement cap rates. Unlike cap rates, which only use the first-year NOI and purchase price, the IRR calculation factors in NOI for multiple years as well as the sales proceeds, so it’s a more comprehensive look at a project’s overall returns.
IRR also allows investors to compare various investment opportunities, including but not limited to real estate deals, and allows for leveraged returns to be compared.
When to Use Cap Rates vs. IRR
There are different situations in which investors would want to use cap rates, IRR, or both.
IRR is a particularly useful tool in that it considers the term of the investment, which is valuable when looking at short to medium-term investments, or those that have a fixed period and projected exit strategy. For smaller projects, such as two and three-family home investments, knowing the cap rate might suffice. But for bigger projects, like Class A apartment buildings that have institutional investors in the deal, there is likely to be a set term upon which the investors are expecting to be repaid. In situations like these, calculating a projected IRR is essential and the only way to get to that number is by also projecting an exit cap rate – so both calculations are needed.
As noted above, any investor who wants to compare investment opportunities including the cost of capital will want to use IRR, as IRR can be calculated both with and without leverage. Cap rates never factor in debt.
The most important distinction between cap rates and IRR is that cap rates provide only a snapshot of the value of a property at a given moment in the investment lifecycle, whereas IRR provides for an overall view of the total returns on the investment on an annualized basis.
Cap rates and IRR are both useful tools for projecting the returns an investor might expect to earn. There are others. And to be sure, both of these tools have their own shortcomings. That said, looking at cap rates and calculating a property’s IRR should be a requisite step in any investor’s underwriting process.