IRR v. Cap Rate

4 Replies

  1. Hi all,

  2. I was wondering if someone can explain in clear and simple language how is a Cap Rate different from IRR.
  3. I understand Cap Rate (NOI/Asset) and kinda understand IRR.
  4. Correct me if I'm wrong: It is when the NPV becomes zero. i.e. above it NPV is negative. Thus the higher the IRR the better. It needs to be higher than my cost of capital. However, is it by definition always higher than the cap rate?

  5. Can they sometime be the same? Is it different in that IRR relates to multiple future cash flows while cap rate is a fixed rate in time?
    When would you analyze an asset with IRR and when with a Cap Rate? 
  6. Perhaps @Frank Gallinelli  would like to comment. My questions rose after reading his great book "What Every Real Estate Investor Needs to Know About Cash Flow..."

  7. Thank you in advance!!

  8. Tal

Hi Tal --

You are correct that the IRR is the discount rate that causes the NPV of all cash flows to equal zero.

Regarding the difference between cap rate and IRR: You are also correct that the cap rate looks at a property's performance at a given point in time. This is why a commercial appraiser might prefer to capitalize the current year's NOI in order to estimate value, because he or she is trying to give an estimate of value as of a specific date.

IRR, on the other hand looks at the income stream over time. It might relate to the purchase, NOI, and gross selling price (so-called unlevered IRR); or it might use the cash invested, the after-debt-service cash flow, and cash proceeds from sale (so-called levered IRR).

It is worth knowing the capitalized value of the NOI since that presumably is what the property is "worth" today, and it is the value on which a lender will probably base financing. However, from the investor's perspective, it is even more important, I believe, to keep in mind that you are not investing for a point in time but rather for a longer term. For that reason, you want to develop some sense of how the investment will perform over the entire period you wxpect to hold it.

You may be able to anticipate the ebb and flow of your future NOI or cash flow within some reasonable range and thus perform an IRR calculation over your expected holding period. (For example, you property may have commercial leases with pre-defined step increases; or you may expect loss of revenue at the end of a lease term while you re-fit a space and seek a new long-term tenant). I always recommend using best-case, worst-case and in-between set of assumptions to decide in you can accept an investment that performs somewhere within that range.

Shorter answer: Income capitalization and IRR are different, but both are important. One seeks to establish a market value at a point in time, the other to give a sense of the investment's performance over the entire holding period. Ultimately, as an investor, I think the IRR has to trump the capitalized NOI -- in other words, if the property seems unlikely to meet my rate-of-return goal at the presumed current market value, then I want to find the value at which it WILL meet my goal.

Frank

Medium logo realdataFrank Gallinelli, RealData | http://www.realdata.com | Podcast Guest on Show #4

Frank,

Very good points about IRR. As a lender, we typically are basing what we will lend based on CAP rate, but the future value of the property is so important. Another criteria I will sometimes consider is the balloon payment at the end of the loan term. An example would be a dollar store where you have a new 10 year lease. Today the cap rate might be between 6 and 7%, but at the end of 10 years, the cap rate might be between 9 and 10, maybe even higher without a renewal. As a lender, I want to make sure the balloon will be manageable for the owner so that he will be motivated to stay with the project.

Mark

Originally posted by @Tal B. :
  1. I was wondering if someone can explain in clear and simple language how is a Cap Rate different from IRR...Can they sometime be the same? ...When would you analyze an asset with IRR and when with a Cap Rate?

The internal rate of return IRR and Net Present value NPV are concepts you encounter frequently when discussing capital budgeting and also is utilized with real estate investments.

Regarding your question..when would you use an IRR? Using real estate investments for instance, whenever you make an investment where there is an initial outflow of funds (the investment say to buy an apartment building) and there is yearly net income from that investment (rents), you could use an IRR to determine the profitability of that particular investment compared to other buildings that you might be considering. (Assuming the investments are similar and that you have the same cost of funds on all the investment alternatives).

So the IRR is the rate that causes the Net Present Value (present value of all future project cash flows) to be zero but this shouldn't cause confusion. It might help to think of it as the discount rate where the investment breaks even or where the present value of future cash flows equal the all cash outflows within the period being examined.

You of course always want the IRR to be higher than what the cost of funds or discount rate is.

There are of course problems with the IRR-- the multiple IRR problem, accounting for inflation issue and its use in evaluating single period investments, but that's stretching the discussion beyond your initial inquiry.

On some investments the concern is on the magnitude of the investment in terms of what wealth is being created for investors and in that case the Net Present value might help or be more relevant.

The capitalization rate or cap rate, is mostly strictly utilized in evaluating income real estate investments whereas the IRR and NPV are concepts that apply to various types of financial investments not just real estate.  It is also not unusual to hear folks in other circles use cap rate term so you have to be aware of the context.

The IRR and the Cap rate are different investment evaluation tools and not the same thing.

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