It’s no easy feat to determine the benefits and risks of a possible real estate investment. In order to do this, you’ll need many tools at your disposal. Cap rate and internal rate of return, or IRR, are two of the most common factors that real estate investors use to understand the value of the property. Here at Trion Properties, we make every real estate decision with a comprehensive calculation based on long-term and short-term factors. Here’s our guide to two of the most important elements with which you should become familiar.
What Are Cap Rates?
The term “cap rate” is often used by commercial real estate investors. Simply stated, a cap rate (technically, “capitalization rate”) is a formula used to estimate the potential return an investor will make on a property. Knowing a property’s cap rate is one way for investors to compare opportunities.
The cap rate is expressed as a percentage that varies according to asset class, quality of asset, stage of the cycle we are in, and other factors, and have an inverse relationship to property value – the higher the value, the lower the cap rate, and vice versa.
The cap rate for a building is derived by dividing the net operating income by the price or total cost of the building. For example, a building with $500,000 of net income that cost $10 million to purchase will be said to have a 5% cap rate. Similarly, cap rates can be used to calculate the value of a building. For example, if in a particular geographical area, apartment buildings of the same age and caliber are selling for 5 caps, then a building with $1 million of net operating income will be valued at $20 million.
Terminal Cap Rates
A terminal cap rate, sometimes referred to as the “exit rate,” is an important metric in property investment analysis because it is one of the key inputs in calculating the resale price of a property. It is calculated by taking the expected net operating income (NOI) of the last year of the holding period and dividing that by the terminal cap rate (expressed as a percentage) to get the terminal property value. Terminal cap rates are estimated based on comparable transaction data and can be used as a guide depending on a property’s specific location and attributes. If the terminal cap rate is lower than the going-in cap rate, it usually means the investment was profitable over the course of the holding period.
Pro Forma Cap Rate
There’s a distinction to be made between a purchase cap rate and a pro forma cap rate. The purchase cap rate, otherwise known as the “going in” cap rate, looks at the current cap rate based on existing rents, vacancies, etc. This is the actual cap rate at the time the property is purchased.
Conversely, the pro forma cap rate is based on the after-repair and stabilization value of the property. The pro forma cap rate is calculated based on many assumptions the prospective buyer or developer makes when running their numbers and should be used cautiously except amongst the most experienced CRE investors.
How is Cap Rate Determined?
Cap rates are calculated using a specific formula. That formula is:
Net Operating Income / Property Value or Cost = Cap Rate
The net operating income (NOI) is usually the actual NOI for the property over a one-year period. The property value is typically the seller’s asking price for the property, or the purchase price the investor is expecting to pay for the property.
It is important to understand that debt is not part of the cap rate calculation. This is one of the reasons why cap rates are such a valuable tool for investors. By excluding debt from the calculation, prospective investors can do an apples-to-apples comparison of different investment opportunities. The problem with including debt is that depending on the investor’s profile, equity, and terms of the deal, the financing package can vary drastically.
For simplicity’s sake, therefore, cap rates always assume a property is purchased for cash without leverage and for this reason provides a good comparison of one deal against another without the variable of debt skewing the numbers.
Why is Cap Rate Important?
There are several reasons why cap rates matter to investors. First and foremost, cap rates are a point-in-time snapshot that investors can use to compare different investments at a given moment. More specifically, cap rates provide a degree of insight as to how much risk an investor would be taking on with a particular property compared to other investment opportunities.
Generally, the higher the cap rate, the more risk associated with the property. For example, a Class C apartment complex located in one of Los Angeles’s fringe neighborhoods might have a 6% cap rate compared to a Class A multifamily property located on the westside of the city, which might have a 4% cap rate.
Cap rates also provide valuable insight as to how a property stacks up against others in the same asset class and market. It provides a baseline for investors looking to understand how one property might compare to the others, and what improvements may be needed to bring the property in line with market averages, thereby improving the investor’s overall returns.
What is IRR?
An internal rate of return (IRR) is another way to value an investment opportunity. The IRR attempts to express what someone will make on an investment over the course of the entire holding period, taking into consideration potential changes in income, property value, and debt service. IRR expresses total returns on a project, though they may vary from year to year, on an annualized basis.
In short, IRR is a rate of return that describes the sum of all future cash flows, including the profit made on the sale of the asset. The sooner the same earnings from an investment are received, the higher the IRR.
How is IRR Determined?
Calculating IRR is somewhat complicated. It is an abstract concept that considers the time value of money and the rate of return the investment provides over the entire life of an investment. According to the basic time-value of money principle, a dollar received today is worth more than a dollar received in the future given inflation. The IRR is essentially a way to discount earnings received in the future. The further in the future earnings are, the less valuable they become.
Therefore, in order to determine IRR, you first need the yearly cash flows the investment property is projecting to produce or has produced. The cash flows include both: (1) cash flow from rent; and (2) cash flow from the sale of the property and you must know how much is coming from each to be able to calculate the IRR.
The challenge with calculating IRR is that it can be difficult, even for the most sophisticated investors, to forecast future cash flows and sales proceeds. As such, more conservative investors will only use actual numbers to calculate a realized IRR instead of forecasted.
A few other things to note about IRR:
- The sooner the same earnings from an investment are received, the higher the IRR.
- Therefore, a project with a higher IRR does not necessarily mean it’s a “better” investment than something else. A higher IRR could translate into the same cash flow received, but at an earlier point in time. A project with a lower IRR could actually have better gross returns, but later in time.
- IRR calculations do not take into consideration the risk profile of a project or other variables that could potentially impact overall returns.
Why is IRR Important?
IRR is an important metric in that it can be used to supplement cap rates. Unlike cap rates, IRR tells the whole story because not only does it include the profit made on the sale of the asset but it includes the levered cash flow received after debt service and other below the line expenses.
IRR allows investors to compare investment opportunities across the board, not just those in commercial real estate and allows for leveraged returns to be compared. The IRR calculation helps to equate funds flow over different periods to their net present value, thereby applying the economic concept of time value of money. This concept stipulates that a dollar today is worth more than a dollar tomorrow, due to inflation, opportunity cost, and risk. Using IRR to calculate the discount rate of cash flows ensure each cash flow is given an appropriate weight by discounting that cash flow by the time value of money.
Many investors also like using IRR because it does not require a “hurdle” rate, such as the rate of capital investment or cost of capital. IRR can be calculated independently, and investors can then compare their own individual estimated cost of capital to the IRR as they so choose (as the cost of capital can vary widely depending on the investor’s profile, amount of equity in the deal, banking relationships, and more).
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When to Use Cap Rates and IRR
There are different situations in which investors would want to use cap rates, IRR, or both.
IRR is a particularly useful tool in that it considers the term of the investment, which is valuable when looking at short to medium term investments, or those that have a fixed period and projected exit strategy. For smaller projects, such as two and three-family home investments, knowing the cap rate might suffice. But for bigger projects, like Class A apartment buildings that have institutional investors, there is likely to be a set term upon which the investors are expecting to be repaid. In situations like these, calculating a projected IRR is essential and the only way to get to that number is by also projecting an exit cap rate – so both calculations are needed.
As noted above, any investor who wants to compare investment opportunities including the cost of capital will want to use IRR, as IRR can be calculated both with and without leverage. Cap rates never factor in debt. Different properties support different leverage amounts and types of debt, which is why IRR provides an important perspective to sophisticated investors.
The most important distinction between cap rates and IRR are that cap rates provide only a snapshot of the value of a property at a given moment in the investment lifecycle, whereas IRR provides for an overall view of the total returns on the investment on an annualized basis.
Cap rates and IRR are tools for evaluating returns in a project. There are others. And to be sure, both of these tools have their downfalls. We’ve already touched upon some of limitations of cap rates. IRR has its shortcomings, too. For instance, there could be years with negative cash flows, in the event major capital improvements are needed or if there’s a substantial disruption in cash flow.
In either case, it is difficult to predict the future and therein lies the challenge. We don’t have a crystal ball and can’t predict what rent growth will be or what a sales price will be. Therefore, even pro forma cap rates and IRR calculations are imprecise.
That said, looking at cap rates and calculating a property’s IRR are a requisite step in any investors underwriting process. Many investors feel uncomfortable running the numbers on a deal, and understandably so—there are many factors to consider, overlook any one and your numbers could prove fatally flawed. Check out our portfolio at Trion Properties to see how expert investment strategies can lead to success.