A common question when attempting to value a commercial real estate deal is “What return metric should I use?” Common metrics include, Cap Rate, Cash on Cash and IRR. All of these metrics approximate an annual percentage return you will receive on your investment. Which metric is the most useful? Let’s first look at how each metric is calculated.
The cap rate is a common industry term which can be determined by dividing the NOI of your building by the acquisition price of your building. So, in the event you got a new property for one million dollars and during the first year your net operating income was one hundred thousand dollars, then your cap rate will be 10 percent or you would say that you just bought the building at a ten cap. Cap rates can also be used to approximate the acquisition price for a certain building. Riskier investments require higher returns, as such; a riskier building would require a higher cap rate from an investor. A safer building would require a lower cap rate and thus, be acquired at a higher acquisition price.
Cash on cash is another real estate industry term that is calculated by dividing the investor’s cash flow from a property of a particular operating year with the amount of equity or cash the investor has invested in that property. So, if the investor put up 100 thousand dollars of equity to acquire a property and during a certain year he or she received eight thousand dollars in income after all expenses and debt service, then this investor’s cash on cash return for the period was eight percent. Another derivative of cash on cash that is similar is called cash on cost. Rather than the equity investment for an operating property, this metric uses the expense of building or renovating a property and also the associated cash flows the property will generate.
IRR is a general finance term that is commonly used in commercial real estate. IRR stands for internal rate of return and is calculated by using all the cash flows an investor will make (positive and negative) over the course of the investment period. IRR represents the average annual yield the investor will realize over that time period.
What are the differences between these return metrics? Cap Rates are usually used in analyzing the purchase and sale of properties. They only look at the transaction event in that specific time period and do not look at the entire string of cash flows. Cap Rate is a good way to get a quick judge of how a particular property is being valued. Cash on cash looks at the individual cash flow periods and does not look at appreciation of the asset upon exit. IRR looks at the entire cash flow of the investor and is a more exact approach to valuing an investment.
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