Is the CAP rate the best financial metric? A case for the IRR.

One of most interesting aspects of multifamily/investment real estate are the various ways you can develop your financial analysis. As a CRE broker/investor/property manager,  I have been working with buyers and sellers for over 21 years and 1000's of transactions as a CCIM (Certified Commercial Investment Member), which only 6% of all commercial agents/brokers have obtained. As well, along the way I rounded it out with an MBA and a J.D. In my career, I have individually acquired over 475 properties. In my 21+ years, I have literally witnessed 100's of different financial metrics used to determine how to sell or buy a property. Needless to say, investment real estate is not a one size fits all proposition, and that is where creativity and ingenuity come into play. 

Multifamily 101 tells us that the CAP rate (capitalization rate) is the best metric, and certainly the most commonly recognized way of determining value. A simple definition of the CAP rate is that it is the ratio of the Net Operating Income (NOI) to property value/listing price/buying price/threshold value. When I work with a seller, a starting point is determining the CAP rate. When I present a property I have listed or that is listed by another brokerage to a buyer, we look to the represented CAP rate as an initial determination of value. 

However, in at least 75% of my experiences with clients, the analysis of the CAP rate doesn't reflect important expenses like credit losses, legal costs, capital reserves, and the investor's time value money so to speak in the deal. As well, the CAP rate doesn't provide any metric for rent increases and other steps to raise NOI over time.  In the end, a CAP rate is a snapshot in time, but NOI is quite fluid from Q to Q and certainly from YR-to-YR. The median CAP rate in the Phoenix area in 2015 is a little shy of 6%, but that has gone down quite a bit over the last 18 months.  The days of demanding an 8+ CAP for a B property are long gone. But if the real estate cycle could be compared to an 18 hole round of golf, are we on the back nine at this point with property value appreciation? I hope to engage in much more detail with other Bigger Pockets members about the almighty CAP rate. But for now, let me say this. The CAP rate is worth consideration and definitely matters to the lender, but DON'T LET THE CAP RATE CONTROL YOUR INVESTMENT DECISION. Put together a 5 year business plan (this post assumes long-term investment strategies only). Work with an investment professional or investment friend, consultant, etc. who can explain and calculate the IRR (Internal Rate of Return). Understand the IRR to make your real estate decision. 

The IRR is the internal rate of return. For every dollar you invest, what percent do you make on it? If you invest $1 dollar, and you make $.20 cents on it, then you have a 20% IRR for the time period used for consideration. Synonyms for the IRR are yield, ROI, and just return. The IRR is not your cash-on return, it is not your CAP, it is not your DCR. Rather, the IRR is what you should start with as your financial metric in making every long-term investment decision. 

In the last few months I have closed several deals, in particular three mid-sized multifamily transactions. All three investors had different investment strategies. One seller, two buyers. Buyer #1 looked at the current CAP and highly stabilized tenant base, and liked that the property had minimal deferred maintenance. The CAP was about an 8, but the IRR over 5 years was potentially over 15%. That return is appealing because it was a 50% better return on his investment than he has experienced in the mutual fund/stock arena with an expected 10% return. Buyer #2 had a very strong CAP at about 10% on the way into the investment, but the real appeal came when I showed them my financial analysis over 5 years. With an aggressive rental increase approach, they may be able to see a 20-25% IRR. But the property has deferred maintenance, it needs some tenant upgrades, and there is some major time each buyer  will need to dedicate to growing the investment. The buyer group is willing to take on the short term pain for the long-term gain. 

Completely different investment strategies, but with an eye to the IRR, they both have made strategic financial moves that should bode quite well for them over time. Interestingly, Seller #3 based much of his analysis on what he paid for the property. His selling price was set based on getting the return he projected when his group bought the property. We did not engage much on his internal process for determining what return was adequate to justify the disposition. But I certainly marketed the property based on the IRR, because the CAP rate was mediocre. Though the CAP rate was not a strong suit, the building is extremely well-maintained, has some ornate features, and is under-rented by potentially $75/month per unit. The buyer was focused on what is considered a value-add property: a buy low, add value, sell high situation. But in this case the value was already added. The IRR sold the deal. A savvy investor recognized that the potential IRR of 17% or more would require minimal human capital, just a new rent standard to raise NOI and ultimately the selling price. He believes rents will keep going up, but at a slower pace. This buyer liked the risk and time reduction. Another completely different investment strategy, with the IRR leading the decision. 

The IRR brings all the ingredients to the salad if you will. By looking at projections over 5 years based on the many variables in play, a better informed investment decision may be obtained, whether buying or selling. Every seller was a buyer obviously. Whether on the way out or on the way into the investment, you can't have a complete picture until you build an investment model that considers all of the variables. Can you raise rents 20% over the next five years? Will expenses go up 5% next year? Will the building need a new roof or a new A/C unit sooner than later? What does leverage do for the investment? Why do I want leverage if I don't need it? Could I sell the property for a 5 CAP at EOY 5 because the area is nice, but has a higher ceiling? There are quite a few different variables to consider. The IRR absolutely takes projections into consideration. Many investors comment to me that they don't like the idea of projecting, because it rarely turns out as planned. I get it. You want to work with actual numbers. I am not suggesting you don't use the CAP as a metric. But to truly know your investment from all angles, put it to the IRR analysis.