Where is the focus of most investors today? It appears that the focus has been more concentrated on the CAP rate rather than the IRR. Why is this? One would think that the IRR would hold a substantially higher place in the investors arsenal of analysis tools than it appears to be at this point in the market.  Let’s look at the definition of the CAP rate:  

• Capitalization Rate is a real estate valuation measure used to compare different real estate investments. Although there are many variations, a cap rate is often calculated as the ratio between the Net Operating Income (NOI) produced by an asset and the original capital cost, or alternatively its current market value.
• More simply put, capitalization rate is the estimated percentage rate of return that a property will produce on the owner’s investment.

In reality, it’s more of a snapshot of the value based on the NOI than a real in-depth analysis. There are many issues associated with it, such as: how was the NOI calculated? Was it accurate? Is it a true reflection of the income and expense picture? Most of the time the other side of the equation (the sale price) is taken from public record, so we know at least one side of the equation is good. But, in order to be accurate, both sides have to be very accurate. If the information is available, knowing what the CAP rate of similar properties in the area are reporting could be a very useful tool, but again, we rely on other peoples calculations of the NOI.  

What is the definition of IRR? The Internal Rate of Return measures annual growth. The IRR is a metric used in financial analysis to estimate the profitability of potential investments. The IRR is a discount rate that makes the Net Present Value (NPV) of all cash flows equal to zero in a discounted cash flow analysis. IRR calculations rely on the same formula as NPV does.

What is the ROI? The Return on Investment measures the overall rate of return over the life of the investment. The ROI is a performance measure used to evaluate the efficiency of an investment or compare the efficiency of a number of different investments. ROI tries to directly measure the amount of return on a particular investment, relative to the investment’s cost. To calculate ROI, the benefit (or return) of an investment is divided by the cost of the investment. The result is expressed as a percentage or a ratio.

So what’s the difference between IRR and ROI? An important difference between IRR and ROI is that ROI indicates total growth, start to finish, of the investment. IRR identifies the annual growth rate. The two numbers should normally be the same over the course of one year (with some exceptions), but they will not be the same for longer periods.

So let’s look at the IRR. The IRR equals the discount rate that makes the NPV of future cash flows equal to zero. The IRR indicates the annualized rate of return for a given investment—no matter how far into the future—and a given expected future cash flow.

A significant contributor to the IRR is what amount of cash you get to keep, and how much you have to give to the government. Property tax is able to be calculated before you buy a property, but what your financial responsibility on a post sale tax rate is something most people worry about after they buy the property.  While it is a complicated formula, it is something that a qualified commercial broker can calculate. Some of the factors that contribute to determining this post tax analysis are what type of entity (LLC, INC, Personally, etc.) the real estate is purchased with, what your personal tax rate is (your bracket), what type of depreciation (Straight-Line or Accelerated) you will decide to take and how much in capital improvements you decide to make.

Real estate provides a substantial number of ways to decrease your tax liability and with the right team and a strategic plan before you buy an investment property you can greatly increase your post tax cash flow.  If you are curious about what you can expect on a future purchase, feel free to reach out to the Coastal Land & Commercial Group or any broker who is a CCIM member. 

Another important factor to consider when you’re evaluating an investment property is when the return on your investment will be seen. The age old question; would you rather have $100 today or $200 at some point in the future. If you are able to tell your commercial broker what your discount rate is, then we can give you a specific period of time you would be required to wait. The discount rate refers to the interest rate used in discounted cash flow (DCF) analysis to determine the present value of future cash flows. A simple way to figure this out is what you would expect as a return on investment if you invested the money in something else. If you’re taking money out of the stock market you might have a discount rate of 7 to 10%, while if you are investing in CD’s you might have a discount rate of .5%.  

When looking at investments it is important to not just look at if you are going to have a positive return on your investment, but when that return on investment is received. If you ever wonder why some properties don’t become developed, or why some developers seem to make a fortune when they complete a project and are able to buy land very cheap, it’s because some of these projects will not see a positive cash flow for years or decades and may only see it when the project is eventually sold.  Knowing how much you need to invest to see a positive return and when you will see it on a project will help an investor have more winning projects.

A great commercial broker is really a financial advisor in all things commercial and investment real estate.  If you are not able to get a cash flow analysis, a CAP rate versus IRR report, or your advisor can’t give you a time value of money report, or estimate of post tax cash flow, you might want to find a commercial broker who can help you with these analyses and make ensure more investment properties turn a profit for you. Feel free to call us!  

– Written by Dave Garvey & Ethan Ash

– Addt’l Resources: www.Investopedia.com