First, what is a cap rate, or capitalization rate? Very simply, it is the income that is produced over the cost. To be more specific, it is the NOI (Net Operating Income) over the value or purchase price for a given property. Essentially, it is the percentage of income that a property produces and it is the most widely used real estate investment yardstick in the world. Everyone uses it because it’s easy to understand – “I spend this and I will get this.” But, the limitations of it are astronomical. How long is the money invested? What is the financing look like? Will the investment require further cash? How much will I sell it for? The list goes on.
Don’t get me wrong, it is a great measure - it just lacks some of the data that real estate investors need to know. So, it’s not false, it’s just incomplete. That is why you need to snuggle up with IRR (Internal Rate of Return). It is a cap rate on steroids and provides a more complete picture of the return on investment.
There are three key questions that we should ask:
1) How long is the money invested?
2) How much money does the investment require (upfront and throughout the life of the investment)?
3) How much money will I get at the end -- in other words, time, money in and money out?
The IRR yardstick measures all of that, although there is no simple calculation for it because it considers compounding and reinvesting the cash-flow. We'll get into more detail in a follow-up article.
But for now and as a quick example, consider that an investment property may have a cap rate of 3 per cent, but an IRR of 10 per cent or visa versa. A property may cash flow 7 per cent, but if you have to dump $20k for a new roof, don’t you think that will eat into your cash flow or income yield?
Here is a very simple rule to remember: cap rate measures income, IRR measures income and growth (good or bad). As an investor and an adviser, I am far more concerned with the overall rate of return or yield (as it is typically referred to) that IRR provides. Of course, IRR has some limitations as well (including making projections), but it is a more complete tool that all investors should get to know in addition to others such as cash on cash.
Adam Brind is the Broker of Record of Core Assets Inc. The real estate brokerage, based in Old Town Toronto, takes an holistic approach to real estate goals, with special dedication to investment properties. If you're interested, in a sample spread sheet for calculating IRR, email Brind at [email protected]