For investors of commercial real estate, it can be easy to get lost in all the analytics, data, and information that all go into evaluating a good deal.
There are many factors to consider when evaluating deals, including:
- Property Details (i.e., location, number of units, square footage, etc.)
- Cost (i.e., purchase price, cost of rehab. Improvement, etc.)
- Financing (i.e., loan amount, down payment interest rate, closing costs, etc.)
Once investors establish a comfort level with the property, location, and market, it all comes down to the bottom line. What can an investor expect to make from an investment?
It’s human nature to want the abridged version of everything. In a digital age, we want all our information handed to us in neat little packages like 280-character tweets and Instagram snapshots. It’s no different with commercial real estate investing.
However, when asked, what is the expected rate of return? The answer to that question is not always straightforward since there are several metrics for projecting the potential financial benefits of an investment.
In this article, we’ll restrict our discussion to three metrics for projecting the potential return from an investment: cap rate, return on cost, and internal rate of return (“IRR”).
Cap rate is probably the most accurate forecast of what an investor can expect to make in the first year of an investment because it’s based on actual current year numbers.
The cap rate is calculated by dividing the most recent year’s Net Operating Income (NOI) by the purchase price. Assuming nothing changes, an investor can expect a return equal to the Cap Rate in the first year of investment.
The cap rate is useful as a snapshot of what an investor can expect in the short-term. It’s also helpful in benchmarking one property against another in the present. But it doesn’t take into consideration value-add opportunities or long-term returns.
For instance, a multifamily property can have a negative NOI and, therefore, a negative cap rate today, but could still be an excellent long-term investment.
This is because with the right value-add, both the occupancy and rents can improve dramatically. So, as in that example, the cap rate in the first year may be negative, future returns could be positive and well worth the investment.
Return on Cost
Return on cost is a forward-looking cap rate that’s effective for projecting returns on value-add opportunities. It takes into consideration both the costs it takes to stabilize a property and the resulting NOI once the property has been stabilized.
Take, for example, two properties:
Property 2 is a value-added opportunity we can acquire for $16 million but needs another $2 million in renovation capital to achieve the same NOI as Property 1.
In the current year, the NOI is $1 million giving us a current cap rate of 6.25%. Once Property 2 is stabilized, it will be able to achieve NOI of $1.4 million like Property 1, but because Property 2 was acquired at a discount, the return on cost (or modified cap rate) is 7.8%.
If we want to compare, going by the cap rate, Property 1 has the advantage, but because the return on cost takes into account value-add variables, Property 2 offers better returns.
Internal Rate of Return
Both the cap rate and return on capital are useful in certain circumstances. Still, neither is very useful for calculating long-term returns and neither one factor in the time value of money. That’s why IRR is a superior metric for projecting a return on investment because it takes into consideration both value-add variables and the time value of money.
Don’t ask a mathematician to explain IRR to you. They’ll tell you that IRR is the interest rate at which the net present value of all the cash flows (both positive and negative) from a project or investment equals zero. They’ll give you this formula for calculating it:
0 = P0 + P1/(1+IRR) + P2/(1+IRR)2 + P3/(1+IRR)3 + . . . +Pn/(1+IRR)n
Where P0, P1, P2… equals P, and n equals the cash flows in periods 1, 2, 3… and IRR equals the project’s internal rate of return.
How clear was that? So, what is IRR in layman’s terms? I like to think of IRR as the compounded interest rate an investor can expect to earn on an investment. A typical CD earns a 2% compounded rate to give you some perspective.
Take the following example of cash flows from a multi-family property:
- Year 1: -$500,000 (acquisition of property + value-adds)
- Year 2: $150,000
- Year 3: $150,000
- Year 4: $150,000
- Year 5: $150,000
- Year 6: $700,000 (sale of appreciated property)
IRR: 14.49% (calculated using a spreadsheet)
Earning the equivalent of a 14.49% compounded interest rate on a property is not bad. It beats the 2% that is obtained from a CD.
In summary, the cap rate provides a useful short-term snapshot of the expected return on investment. However, the future capital expenditures, rent, and expense growth, vacancy, or future sales price, are not factored in.
The return on capital is only slightly more useful since it does take into consideration future capital expenditures. Neither one takes into account the time value of money. That’s where IRR comes in.
The IRR is a more useful tool than cap rate or return on capital in evaluating the returns on a commercial real estate investment for the entire holding period – not just in the first year. IRR takes into account all future cash flow items, revenue, expenses, capital expenditures, rents, occupancy, and future sale prices.
An IRR of 14.49% tells me a lot more about the likelihood of success of an investment than a cap rate of 6.25% or return on a cost rate of 7.8% ever will.
And because IRR takes so many factors into its calculation, skilled investors can play with the numbers to arrive at the desired return – for example, manipulating rent rates, occupancy levels, expenses, etc.
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Investor, writer, speaker, and founder. Kyle Jones, key principal of TruePoint Capital, is accountable for investment decisions, asset management, and overseeing financial activities, operations, and investor relations. Kyle additionally is a Global Sales Leader for a large Fortune 100 technology company. Kyle received a Bachelor of Science degree from Texas State University – San Marcos.