What are the differences between these two metrics?
Real estate investors require effective metrics to analyze investment opportunities. Two of the most popular metrics are:
1. Capitalization rate (Cap rate): the rate of return based upon the net operating income that the property is expected to generate. Cap rate is defined as net operating income divided by total value.
2. Internal rate of return (IRR): the average rate of return a project will generate over its lifetime, inclusive of all cash flow, refinancing and disposition proceeds.
Each metric provides insights into a real estate investment and are often used in conjunction with each other. Each one also has its own complexities that investors should understand in order to evaluate an investment properly.
To illustrate an issue with cap rate, imagine $1.8M invested in a real estate property that generates a net annual income of $125K. The cap rate in this case is 6.9% percent. When cap rates go down, the price goes up and when cap rates go up the price goes down. Using the same example, if the investor paid $1.5M it would be an 8.3% cap and if the investor paid $2M it would be a 6.25% cap rate.
Calculating IRR is a complicated affair that relies on a forecast of future cash flows, which in turn can be affected by general market conditions, cap rates and a myriad of future events and assumptions. Once calculated, the IRR provides the investor with an annual rate of return over the life of the investment. Using an opportunity cost of capital theory, this IRR can then be compared against other potential investment opportunities and the risk associated with each. The investor then has the ability to select the investment opportunity which has the best returns, in light of the corresponding risks of investment.
IRR, however, can be materially affected by the duration of the hold. For example, a quick flip will likely have a significantly higher IRR than a 10 year hold, however, the whole dollars received by the investor will likely be materially less. In order to adjust for the fluctuations of IRR and time, investors typically view IRR in conjunction with equity multiple, which looks at multiples of cash that are received over the holding period. Therefore, if a quick flip opportunity presented itself whereby an investor could invest $100K and post-flip would have $110K, the investor might make a high IRR but the equity multiple would be 1.10x and the investor would have to decide whether the risk warranted this 10% return.
Implications for Real Estate Crowdfunding
An attractive feature of real estate crowdfunding is that investors have the opportunity to make multiple, smaller investments. This means investors can participate in several projects that have positive IRRs, diversifying their property portfolio and thereby reducing their overall risk.
As always, investors should gather all available information about an investment before putting their money at risk.