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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Title III Crowdfunding Now Everyone Can Invest

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Well last Friday it finally happened. The SEC passed Title III of the JOBS Act which effectively allows non-accredited investors to invest in private placement investment deals. In plain English this means when you visit any of the crowdfunding platforms they will allow you to view and invest in their offers without confirming that you are an accredited investor. Well at least in theory this will be the case.

On the surface this seems like the day we have all be waiting for in the crowdfunding industry but in reality it may have limited impact. While everyone has been jumping for joy about the new legislation and don’t get me wrong there is a lot to jump for here, there are still some issues. The problems are basically due to the capital limits placed on the deals which can be offered to non-accredited investors. In the current version of Title III the maximum that can be raised in these offerings will be $1 Million dollars. This may seem like a lot, but for most high quality real estate deals the capital limit basically prevents any of these deals from opening up to the small retail investor.

In my opinion the greatest potential crowdfunding offers retail investors is precisely in these type of investments which are relatively lower risk investments compared to start-up investing. The limit will have a small impact on the start-up investing platforms such as and as most of these offerings are for less than $1 Million dollars. This is the exact issue that Nav Athwal, CEO of addresses here.

There are other issues regarding the additional regulatory hurdles which will be placed in front of the companies wishing to take advantage of this new legislation as Tanya Prive points out as well. You can read more about her concerns here.

In contrast to the issues raised by Athwal who runs a real estate crowdfunding platform, Chance Barnett CEO of a platform for startups, was singing the praises for the new legislation in his article here.

The contrast of these two views I think is really dependent on what Athwal pointed out. The implications of Title III are vastly different for real estate platforms as opposed to start-up platforms. The start-up platforms have a lot to gain as most of their offerings will fit under the $1 Million dollar cap and due to inherent riskiness of investments into start-ups investors will in any case want to commit less of their money to these investments. The opposite is true for the real estate platforms, which need more capital for each deal and are inherently much more stable investments which attract larger investments from each investor, the investment caps on these type of deals will seriously hinder the participation of retail investors.

One of my major concerns as well is that when the legislation actually goes into effect the start-up platforms will be the first to adopt offerings under title III. The hype and exuberance on the part of many retail investors to get in on these deals will lead to money flowing in without sufficient due diligence and without the proper hedges against risk. Since these are the most risky investments in the crowdfunding space it is really a horrible place for us to have to start with retail investors. A few deals that go bad and with start-ups the majority go bad will put a black cloud over the industry in terms of retail investors and this is all before the real estate platforms will be able to figure out the proper way to take advantage of the new legislation.

I hope for the industry and for investors both platforms and investors will proceed with caution using the proper due diligence and diversification to invest.

What Is Wrong With Title III Crowdfunding

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Not everyone is so convinced about the prospects of Title III of the Jobs Act which was recently passed by the SEC.We thought we would post some thoughts from around the web on the issues with the current legislation.

Nav Athwal, CEO of voiced his concerns about the legislation because the capital limits effectively exclude real estate deals.

Athwal writes:

In theory, it seems like a win-win for both sides but putting the Title III changes into practice may not be a realistic goal at this stage of the game. At my two year old crowdfunding for real estate startup RealtyShares where the goal has always been to cater to the general public and not only Accredited Investors, we’re struggling to determine if this rule is actually as impactful as it appears to be in theory. That is because while Title III does expand crowdfunding opportunities for non-accredited investors, there are still certain requirements that have to be met and restrictions that apply.

For instance, under Title III individual investments would be limited to either 5 or 10% of the investor’s gross annual income, based on their net worth. And any investment opportunity would be capped at $1 million in total fundraising within a 12-month period. For commercial real estate, a capital intensive asset, these upper limits could be very limiting.

In recent weeks, legislators have been making a push to have the cap raised to $5 million and reduce some of the cost to crowdfunding platforms with regard to Title III offerings. It’s not clear yet which way the SEC will rule on these issues. In terms of the logistics of vetting non-accredited investors and making sure investment deals fall within the guidelines Title III imposes, the challenge may be too much of an obstacle for more nascent startup platforms to take on.

Other verticals, particularly those catering to startups or small businesses, will reap some positive benefits from Title III and those benefits extend to the public as a whole. Unlike real estate, oftentimes startups and small businesses do not need as much cash to hit that next milestone and thus the upper limit of $1 Million could prove workable. On the whole, however, the rules in their current form may not carry as much weight as previously thought.

You can read the full article here.

Other concerns were voiced by Tanya Prive, which concern the higher regulatory demands that will be put both on platforms and start-ups themselves to be allowed to open their offerings to non-accredited investors.

Prive writes:

Plus, a detailed due diligence screening conducted by the intermediaries or their outsourced partners will need to take place before the deal can be admitted, which can take anywhere between 15- 90 days. It will examine every little aspect of the company, its officers and major stakeholders, which depending on whether the intermediary does this in-house or outsources it, will result in additional fees, typically ranging between $2K-$5K. To build on top of that, there is no good way of making this process truly scalable as each due diligence conducted is unique in a way to the company undergoing it.

Read Prive’s full article on Forbes.

It remains to be seen how effective the new legislation will be as well as how many of the platforms will actually start adding offers under Title III. Keep reading more on this issue.

Real Estate Lending: Bridge vs Term Loans

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When thinking about investing in any debt instrument there are multiple things that need to be considered. The most important metrics most investors are looking for are loan term and return, but in real estate there are a variety of other considerations that often cause investors to misprice risk. As RealtyShares rolls out its term debt product, the focus of this blog post is to educate potential investors on what we are thinking about when we’re looking at interest rates and how to price our term debt product relative to our bridge debt product.

Short Term Acquisition Financing (Bridge Debt)

The most popular product on the RealtyShares platform from both a borrower and investor perspective is the short-term bridge product. We launch roughly 2-4 short-term rehab loans per week and the investments are sold out within hours, if not minutes. The reason this product is so popular from an investor’s perspective is because of the high interest rate, short duration of the loan and the personal guaranty from the borrower. From a borrower’s standpoint, these are attractive deals despite the high cost of capital because of how difficult it is to obtain traditional financing and because the loan is outstanding for only a short period of time. He or she is willing to take the high interest rate in order to secure capital to close quickly and leverage the potential return.

High Interest Rate

Short-term acquisition and rehab loans are no doubt attractive investments, but they still come with a degree of risk. These assets are typically not producing cash flow from day one of the investment term and there is uncertainty on the ability of the borrower to A) complete the project successfully while paying interest, B) pay the loan back at maturity, and C) sell or refinance at a high enough value to cash out the lender. RealtyShares mitigates these risks by underwriting both the borrower and the property securing the loan, while investors are compensated for this risk with a high monthly coupon payment. The borrower will pay a higher rate because fix and flip projects are high margin and the biggest limiting factor for high volume fix and flip operators is access to capital and efficiency of capital.

Term Debt Product

While many borrowers are utilizing short-term bridge loans for a fix and flip strategy, there are equally as many repaying the initial loan by refinancing and holding the property in a rental portfolio. In a buy and hold scenario, borrowers are able to obtain a longer term loan at a lower rate after they have completed rehab and placed a renter in the property. The rate is lower because a majority of the risk has already been eliminated for several reasons.

Debt Service Coverage Ratio (DSCR)

When an asset has been stabilized and is cash flowing, there is a greater degree of certainty for a lender that the borrower will have the ability to pay the monthly interest payments using the cash flow that the asset is generating. When evaluating a loan, lenders are focusing on the debt service coverage ratio to determine whether the income from the asset is covering the debt service. The formula for debt service coverage ratio is simply the monthly net income from the asset divided by the monthly interest payment.


  • Loan amount: $100,000
  • Interest Rate: 6%
  • Monthly Debt Service: $500
  • Monthly Rent: $800
  • Monthly Expenses: $200
  • Net Income: $600
  • Debt Service Coverage Ratio = Net Income / Monthly Debt Service = $600 / $500
  • Monthly Debt Service Coverage Ratio: 1.20

The example above has a DSCR of 1.20. 1.20 is typically the minimum debt service coverage ratio a lender will accept before providing financing on the asset. The lender feels good about the loan because the property is generating enough cash flow to cover the debt while the borrower is still able to profit on the asset. The higher the debt service coverage ratio (say net income is $700 in the example above and the DSCR is 1.40) the more favorable the financing terms will be for the borrower.

After Repair Value (ARV) and Loan to Value (LTV)

The other reason a lender can get comfortable with a lower rate and a longer loan term for a stabilized asset is more certainty around the value of the asset that is securing the loan. When evaluating ARV before work is completed, there is uncertainty on the quality of the final product, which has a significant effect on the value. Once repairs are completed it is much easier to estimate value and typically a lender will not provide term financing without an appraisal, which includes a full interior and exterior inspection of the subject property and a thorough comparable market analysis. Once the value of the property is determined, in most cases, lenders will provide financing up to 75% of that value (75% LTV). At this point, the lender is betting that the market will not depreciate by more than 25% over the term of the loan and if the borrower isn’t able to make payments, the lender can foreclose and quickly sell the home at a significant discount to market in order to recoup the entire loan amount. In some cases, in a rising market, foreclosing can even be the most profitable outcome for a lender.


The last piece to the term loan that is significantly different from a bridge loan is that term loans typically include an amortization schedule; meaning part of the principal is paid down along with the interest each month. In a typical term loan with a 15 year amortization schedule, the lender is receiving part of the principal back each payment period mitigating the lender’s exposure as the loan matures and with payment a small portion of the risk is transferred from the lender back to the borrower. In the 15 year amortization scenario on a 3 year loan, the borrower has already paid back 1/5 of the principal by the time the loan comes due, while in a short term rehab loan that is typically interest only, the lender has the same risk exposure at month 12 as he does on day 1. As the principal is repaid, the default risk decreases as well as the lender’s exposure to fluctuations in the market because leverage goes down with every payment.

Risk Adjusted Return

Pricing risk is essentially based on uncertainty. Uncertainty around the borrower, uncertainty around the project or a combination of the two is driving the difference between a 12% interest rate (for a bridge loan) and a 6% interest rate (for a term loan). Depending on risk appetite an investor may be more interested in a higher coupon payment, however, in finance, just like anything else, you can’t have your cake and eat it too and depending on your risk preferences you may be better off putting your money to work in a low risk long term investment with more certainty that your investment will pay off in the end.