Ok. Let's talk IRR - Internal rates of return - on a real estate investment. I have previously covered CAP rate. (Click Here) You might want to start by reviewing that post.
When I first started buying rental properties here in Fort Myers, Florida, I never used CAP rates to compare properties. I did not trust the numbers that were given to me and quite frankly had never been taught CAP rates. Instead, I evaluated every property I bought on a spread sheet. Into this excel spreadsheet I plugged all my variables: Purchase price, down payment, interest rates, terms, expected capital improvements, and other items like vacancy and credit loss. I would then have a number of spread sheets and make "what if?" scenarios.
On the same sheet I put an expected appreciation rate and my anticipated tax rate. (I forecast when I was going to sell the asset and at what price). What I was building, without really knowing what it was called, was an internal rate of return analysis. I wanted to know that the annual return was on my investment after I had cashed out of it, in say, five years at an annual appreciation of say 5% on the asset.
An internal rate of return is called internal, because it ignores how you might invest periodic cash flow once it is out of the investment. It only looks at return that is internal to the investment.
CAP rates tell you what the annual rate of return is on an investment while you own it ( ignoring debt); The IRR will tell me what the return is on the total investment when you are out, in present value terms.
The IRR evaluates a series of cash flow streams. The first year there is an outlay. This is the year you buy the project. Every economic period there after (Months or Years) there is either an income or a loss. The final year, when you sell the property, you also have an income ( or, God forbid, a loss). IRR takes into account all of these cash flow streams (both positive and negative) and puts a present value on it. IRR's are best calculated in a spread sheet or a financial calculator. Here is a link to a good primer on the subject: ( Click Here). I use the Gary Tharp, CCIM prepared APOD ( Annual Property Operating Data) that includes an IRR calculation for my commercial investments. I always prepare one of these for my clients for every potential investment. (Gary Tharp has made it available for use HERE)
What does all this mean? An investment with an 11% CAP rate and 9% cash on cash is good, but if, at the end of your ownership period, you cannot sell this property because of functional obsolescence, (A restaurant that is outdated, for example, or better yet, a dirt mine that is depleted) then your IRR will be lower (Your cash flow stream will be functionally zero at the end). On the other hand if you have a decent cap rate and great appreciation and are able to sell and get a goodly bump on cash flow the last year - then your IRR well be excellent.
Cape rates are good. IRR is better. Learn to use both.
Gregg Fous
Fort Myers, Florida Real Estate Broker
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