This is definitely something worth knowing! People are always asking ‘What is the difference between “Cap Rate” & “IRR”?’
Firstly, what is “Cap Rate” – it stands for “Capitalization Rate”.
To arrive at the Cap Rate one does the following:
– tally up all the income a property produces for the owner
– tally up all the costs that would be the responsibility of the owner
– subtract the costs from the income and you are left with the NOI
What is “NOI”? – it stands for “Net Operating Income”.
If you divide the “NOI” by the Purchase Price, the ratio expressed as a percentage that you are left with is the “Cap Rate”.
A Cap Rate is similar to, for instance, the interest rate quote you receive from a bank on your savings account.
It is an extremely useful ratio. It is a very quick and easy way to compare different investments as it ignores financing i.e. the “cap rate” stays the same whether you pay all cash for a deal or whether you finance 90% of the deal.
But, it has it’s limitations as well. It is a “snapshot” on a particular day and does not take into account subsequent changes in income or costs.
So, a cap rate is a reasonable tool to use when looking at a NNN deal where the income is the same for maybe the next 10 years and all the expenses are the responsibility of the tenant.
However, when you are purchasing a multi-tenant strip center or shopping center or office building, the “cap rate” could be changing from month to month as tenants move in and out and as expenses fluctuate. A better financial tool in such an instance is the IRR.
What is “IRR”? – it stands for “Internal Rate of Return”.
The IRR takes into account estimated annual cash flows as well as expenses. So, if rents are increasing every year, the IRR captures that information. If expenses are projected to be increasing, the IRR captures that information. If the property kicks off cash and that cash is invested at a particular rate, the IRR can capture that information. If the property is sold at the end of the review period at a particular projected sales price, the IRR includes that final reversion of cash as well!
So… the IRR tells you what each dollar invested into a commercial investment is projected to earn over the investment period you are considering.
So, let’s compare the cap rate on a deal with the IRR to show the difference.
– $1,000,000 = Purchase Price
– 2% Acquisition costs as a % of the Purchase Price
– 7% Selling costs as a % of the Selling Price
– $100,000 = total annual income
– $10,000 = total annual costs
– $300,000 = cash deposit
– $700,000 = amount financed
– Loan: 20-year amortization, 10-year term, 5.5% interest rate
– 10 years: Expected holding period
– Selling Price is assumed at a 9% cap rate
– Contracted rents are increasing by 3% per year
– Expenses are assumed to be increasing by 2% per year
Okay. So, what can we figure out right away? Well… we have the total annual income and the total annual costs so we can work out the NOI. Right?
Yup… so, $100,000 less $10,000 is $90,000. So, the NOI is $90,000.
Also, we know that the NOI divided by the Purchase Price is the “cap rate”. Right?
Correct, so, $90,000 divided by $1,000,000 is 9%. So, the cap rate is 9%. Easy!
But… our rents are increasing by 3% each year… and we financed 70% of the deal. So, what is our return on our investment over the 10-year holding period?
This is not so easy to work out so, I’m going to give you the numbers!
In the image you can see the initial investment going out. It includes acquisition costs.
Then you can see the annual cash-flows coming in to you.
In the 10th year the property is sold and your initial investment and any additional equity that’s built up over time is returned to you.
The result? Well, in this case, with the assumptions we used, your before tax IRR is a healthy 18.71%!!!
This is just over double the 9% cap rate.
So, if you had made a decision based on the cap rate alone, you would have missed out on a great investment. Anybody that can earn around 18% on their money pre-tax is not doing too badly!!!
So, unless you’re buying single-tenant NNN deals with 10 to 15 years left on the lease terms, get somebody to help you analyze the investment in more detail to take into account the annual cash flows and work out the IRR. It could be worth a lot of money to you!
Contact: Lance Langenhoven
Commercial Real Estate Investment Specialist
Cell: 832-483 8655