Say you’ve found an exciting investment property and you’re ready to assess its return potential.
Do you evaluate it based on its CAP rate or its IRR?
WE encourage our clients to analyze both.
“For investors looking to meet certain mid and long-term return benchmarks, it is likely that an IRR analysis will be necessary,” says Gary S. Olschansky, Senior Real Estate Investment Sales Specialist at Trout Daniel & Associates (TD&A). “A CAP Rate calculation does not take the potential future performance of the property into account.”
CAP vs IRR – Defined
CAP & IRR are two metrics that help investors determine whether a property Meets their specific requirements.
The CAP rate, or capitalization rate, is a calculation that establishes the value of a property at a moment in time and serves as a quick and handy tool to compare one investment property to another.
Conversely, the Internal Rate of Return (IRR) establishes return on investment over the life of the investment or some other established timeframe and involves a more thorough evaluation of the property using an income and expense model.
- CAP does not take debt into account while IRR does incorporate debt into its calculation
- CAP uses data from one year while IRR uses data from an extended period
- CAP indicates return on money invested while IRR provides annualized yield on money invested
- CAP uses exact, real numbers while IRR uses estimated numbers using a pro-forma model, which anticipates financial outcomes
“CAP rates are dependent upon the correct calculation of the asset’s NOI (net operating income),” explains Olschansky. “This is determined by looking at income and expenses. It may be possible that the current owner’s expenses are accurate, but not realistic.
For example, many small investors do not include a management fee in their property expenses. While this may work for the current owner most investors do need to include a management fee of anywhere from 3%-7%. This expense affects the bottom-line NOI and therefore, affects the CAP rate.”
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