Cap rate vs. IRR: Who, What, When?

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If you have started looking through real estate crowdfunding offers you have almost certainly come across two popular terms referred to as Cap Rate and IRR (Internal Rate of Return). You have probably figured out that both of these are figures that are relevant the return on your real estate investment or in simple English how much money you will make from the investment. But these terms are in fact different and they are used in different ways in analyzing the returns of a real estate investment. So which is the best calculation to use when vetting your prospective deal?

Keep reading for a more detailed explanation courtesy of one of our  favorite real estate crowdfunding platforms.

What is the cap rate?

The cap rate or capitalization rate is a simple ratio that is determined by dividing the net operating income or NOI by the property’s purchase price or current market value, with the final number expressed as a percentage.

For example, a property that’s valued at $1 million and has an NOI of $100,000 would have a cap rate of 10%. A property that’s valued at $500,000 with an NOI of $25,000 would have a cap rate of 20%. A higher cap rate usually indicates a greater degree of risk and, typically, a higher expected return.

The net operating income refers to the property’s annual return, minus any operating costs such as taxes or maintenance. Expenses related to capital improvements and depreciation are not a part of NOI, so are not factored into the tally.

NOI can be expressed in a number of ways: current NOI, projected NOI after stabilization (that is, after improvements are made to the property to increase rents or raise occupancy levels), or forecast NOI (in the case of new development). It is critical for prospective investors to understand the specific assumptions that are built into the NOI figures as presented.

What cap rate tells investors

The cap rate is a point-in-time snapshot that investors can use to compare different investments at a given moment. Specifically, it offers the investor one measure of how much risk they’re taking on with a particular property, how the property stacks up against similar properties in the same market and what kind of current income they can reasonably expect if all of the assumptions are born out in reality.

It’s also possible to use the cap rate to make an educated guess about an investment’s payback period. This is the length of time required for a property to yield enough profit to recover the initial cash outflow. To get a rough estimate of the payback period, express the cap rate as a whole number and divide it into 100.

For example, if an investment has a cap rate of 10% the formula would look like this:

100/10 = 10 years

Just remember that the payback period isn’t set in stone. There are a myriad of reasons why operating income (the OI in NOI) might change, for better or worse. Rents may decline due to higher vacancy rates or other property-specific or broad factors. Expenses might increase. If the cap rate increases or decreases, the payback period would be correspondingly shorter or longer.

What is IRR?

Like the cap rate, IRR is also expressed as a percentage but it offers one measure of the investment’s value over the entire holding period. In simpler terms, the internal rate of return is the percentage rate earned on the investment during the specific time frame in which it’s invested, assuming a reinvestment of cash flows at the IRR.

For example, an investor who holds a property for five years would earn interest on the income received during the first year for the remaining four years. Income received during the second year would earn interest for the next three years and so on. Taken together, the interest earned on each year’s income would represent the IRR.

Another way of evaluating an investment is to consider the Net Present Value or NPV of the investment. The NPV tells investors whether they’ll be able to achieve their target rate of return, based on the present value of cash inflows and outflows. The IRR reflects the rate of return at which the Net Present Value becomes zero. For financial professionals, NPV is the preferred method of evaluating the economics of a particular investment.

Why IRR is important

When compared to the cap rate, it’s clear that the IRR uses a more multi-dimensional approach to estimating returns. Instead of zeroing on a single moment in time, the IRR projects returns over the entire ownership period based on more than just the NOI and purchase price. This is invaluable for investors who want to avoid properties that won’t allow them to hit their investment goals. IRR and NPV analysis is also more robust in allowing investors to consider changing NOI assumptions over time, or changing assumptions about liquidation value.

While the IRR is used to estimate potential returns, it provides more than just a detailed picture of how much an investor stands to gain. For example, the IRR can be calculated with and without taxes factored in. By crunching the numbers both ways, it’s possible for an investor to determine his effective tax rate for the year.

When to use cap rate vs. IRR

Cap rate is often used as a “quick and dirty” way to estimate value when buying or selling a property and it’s especially useful when working up an offer. For example, if a seller lists the cap rate at a percentage point that’s below the average for similar properties in that same location, the investor might use it to scale their purchase price down.

Investors would also tend to rely more heavily on the cap rate when investing in single tenant properties with a long-term lease. In that scenario, the income is likely going to stay the same and it’s easier to calculate the annual operating expenses.

With an asset like an office building or strip mall, however, where multiple tenants may be moving in and out from one month to the next, it becomes more difficult to get an accurate picture of what the cap rate actually is. In that scenario, the IRR would be a more reliable standard for gauging returns because it looks at projected cash flow over the life of the investment.

If the property’s rents are increasing annually or the operating expenses are creeping up, the IRR will pick up on that information whereas the cap rate won’t because it’s based on the NOI and market value at a fixed point. In short, the IRR is a more comprehensive method for anticipating potential returns.

All financial professionals would agree that NPV and IRR analysis offer investors a more robust estimate of potential return, compared to NOI. As with NOI estimates, however, the assumptions used to produce IRR and NPV analysis are critically important, and an IRR calculation is only as useful as the assumptions that underlie it. It is as important to analyze the assumptions as it is to compare the mathematical results!

The bottom line

Both the cap rate and IRR are useful for assessing whether an investment is worthwhile, though neither one is without certain flaws and limitations. The cap rate, for example, doesn’t take into account financing, which would directly affect the final rate calculation. With the IRR, it’s impossible to predict with 100% certainty what a property may eventually sell for how, at what pace income from rents will grow, or the rate at which cash flows can be reinvested. Unforeseen expenses, changes in vacancy rates, and other factors also affect investment returns and are difficult to predict with accuracy.

Ultimately, both measures play an important part when making investment decisions. Just remember that the cap rate and IRR are only as accurate as the information that’s used to calculate them. That’s why it’s crucial for investors to make sure they have the complete picture on a property before crunching the numbers.

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Understanding Commercial Real Estate Investment Risks

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building-Everyone is excited about investing in commercial real estate with equity based crowdfunding, after all what could be easier? You just put some money into a great commercial property and site back as you watch the 8-12% returns hit your bank account. You own part of a great commercial asset with no downside and a huge upside as real estate prices rise all while you investment is being protected from the erosion of inflation. Sounds great right? Well yes it is but every investor knows that with reward comes risk and the greater the reward the great the risks. Although commercial real estate investing, especially if you are able to get access to blue chip properties in strong locations may have less risks than other areas of real estate investing nevertheless there are risks.

In order to get a better understanding of the risks involved in commercial real estate investing in general and through crowdfunding platforms in particular we decided to share with you this great analysis from Austin @

Rent, Risk and NOI of commercial real-estate

The rental market is the lifeblood of commercial properties. It’s the top line that affects Net Operating Income (NOI) and the main source of annual cashflow to investors. Understanding how rents are priced, why they trend up or down, and how to reasonably predict those trends, is therefore an important factor when analyzing real estate investments.

Recall, the rental market consists of property owners on the supply side, and tenants on the demand side. The dynamics between them contribute in large part to rent and occupancy levels.

Rent is the price granting the right to occupy or use a space for a predetermined period of time, often quoted on an annual basis in terms of square footage. Knowledge of the rental price for a particular property can give an idea of the supply and demand to which that property is subject.
Rent isn’t fixed. It fluctuates based on market conditions. In general, higher rental prices translate to lower supplies and higher demands. Likewise, lower prices indicate higher supplies and lower demands.
In other words, we can specifically say that vacancy rates are a key determinant in the pricing of rents, and also a measurement of the health of a property. Lower vacancy correlates to higher demand and higher pressure on rents, and vice versa.

When gauging vacancy levels, these rules of thumb are generally true:

• A market vacancy of less than 5% or 10% is generally considered a tight market,

• Between 10% and 15% is a moderate market, and

• Vacancy above 15% signifies a weaker market.

Although each product type’s typical vacancy levels can vary.

Net absorption is another key measurement of market strength. Net absorption is the rate at which available space is rented (or vacated) over time. In other words, it signifies market momentum. When net absorption is positive, more tenants are leasing space than vacating it, and vice versa.
The net absorption rate and vacancy rates also indicate how long it will take to re-release a building if a tenant vacates. If the net absorption is positive and vacancy rates are low, available space leases back up in shorter periods of time.

Lease Structures and Rent Fluctuations
Tenants of commercial properties contractually lease properties for pre-determined periods of time. The typical lease structures for various asset classes are as follows:

• Multi-family – 6 months to 1 year.

• Office – 3 to 5 years for smaller suites and 7 to 10+ years for larger suites.

• Retail – 3 to 5 years for inline space and 10+ years for anchors and pad locations.

• Industrial Distribution – 5 to 10+ years.

The fact that tenants are under contractual obligation to pay rent for fixed periods of time helps to mitigate the impact of market fluctuations on NOI and cashflow.

Contractual obligations notwithstanding, tenant credit is still important in determining the risk of inherent in the income stream of an asset. If a tenant goes out of business and leaves prematurely, this will cut into NOI. Therefore, knowing the quality of tenants’ credit aids in analysing an asset’s risk. For example, leasing to Apple, Inc. carries significantly less risk than leasing to a local “Mom & Pop” venture.
When an asset is acquired, there is the possibility for the rent to either increase or decrease, and for tenants to move in or leave. Investors analyze these probabilities based on vacancy rates, net absorption, and determining the quality of tenant credit, as discussed above.
An additional tool that aids in analyzing opportunities or risk is lease comparables (or lease comps), which compares the current rent being paid to market rent. For example, if the current rent being paid is $50 per square foot annually, but market rent for comparable properties is $65 per square foot, that could indicate the potential for rental price increases and therefore increased NOI and cash flow to investors (the reverse is also true as well).

Market Segmentation

Lastly, when analyzing the real estate market, a key fact to keep in mind is that the market is not homogenous. Rents and property value are not the same from one city to the next, or even from one block to the next.
Instead, Real estate is segmented, along property usage type, on the one hand, and location, on the other. Accordingly, supply and demand always correspond to particular types of property in specific locations.
Examples of property types include office, industrial, retail, and multifamily residential. Locations refer not only to metropolitan statistical areas (MSAs), but submarkets attached to MSAs, for instance downtown areas or central business districts (CBDs) and suburban areas.
In effect, rental prices vary according to type and location. 5,000SF (square feet) of Office space in the central business district (CBD) of the metropolitan statistical area (MSA) of San Francisco will not be equivalent to 5,000SF of office space in the suburbs of Chicago. Different market and microeconomic forces ensure that demand varies from one segment to another, leading to differing levels of supply, demand, and rental prices.

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