Cash-on-Cash vs. IRR

9 Replies

I'm new to BP and REI in general. I've been an agent for over a year in Utah and now looking to get some rental properties. I am reading a lot of books and watching a lot of webinars. A lot of investors talk about the cash-on-cash return that a property offers, but I just finished Frank Gallinelli's book, "What every real estate investor needs to know about cash flow...and 36 other financial measures" and in it he talks about how cash-on-cash can be very deceiving and a better metric to use is IRR.

Do any investors go to the length of trying to calculate IRR when they are analyzing properties? Or do you guys use cash-on-cash as a quick and dirty metric to know if you're interested in the deal or not? Has anyone been deceived by an initial cash-on-cash return?

If IRR is used, have you found a good tool to calculate it that integrates well with the BP calculators, seeing as how they only give you cash-on-cash?

@Kyle Ropelato I'm new to investing in UT as well and think this is a great question. I've listened to the first 51 episodes of the BP podcast so far and it seems that a lot of people do things differently depending on where they are. They all find what works best for them.

Excel and Googlesheets both have built-in functions to calculate IRR. All you need is a series of cash flows for each year.

@Nick B. I am comfortable using excel to calculate the IRR, however, is that a step investors take or are they trusting cash-on-cash as a good enough ratio to know it's a good deal? It would be a lot more tedious to try and calculate the IRR on every property your analyze especially when the BP calculators calculate the cash-on-cash for you.

Because I plan on holding my properties for a long period of time I do calculate IRR as CoC does not take into account the time value of money. After year one, IRR will be much more accurate and it's also the most straight-forward route to compare different investments - real estate or other - based on yield.

One last formula to throw in is your return on equity. A much wiser/more experienced investor explained this one to me and it's caused me to slightly adjust my strategy. On year one it will be similar as CoC but as your tenant pays down your mortgage, your equity increases (which is a good thing) but your Return on Equity will decrease. Fast forward 5 years and although rents should go up a few hundred bucks, these rents won't go up as quickly as you are paying down the mortgage. This equity is now gaining a lower return and it may be time to look at alternative options. Quick summary, return on equity is a great metric to evaluate if the equity in the property is being used to it's maximum potential or if it's better move it elsewhere such as leveling-up to a larger property or different asset (note you don't have to sell, you can refi, take a HELOC....etc).

@Tom Shallcross awesome, thanks for the info. That was another topic in Frank's book that he discussed that I found interesting and wondered if many investors actually implemented or not. All I ever hear about is CoC, so I wasn't sure if that's all investors focused on.

Do you try and figure out the IRR on all potential properties for initial analysis or rely on other metrics initially?

@Kyle Ropelato - I'm not in front of my computer but when I am I will send the spreadsheet I use to evaluate my deals. Short answer, I look at lot of different metrics and IRR is one of them. I built out a simple model (you can do the same after one quick Excel formula YouTube video).

It's important to note that IRR can also be very misleading as it's very easy to manipulate, so it cannot be your end all be all metric.   

@Ben Leybovich has several good articles on the subject including this one from a few years ago that really hit home to me: https://www.biggerpockets.com/blog/2014-07-08-irr-use (some good comments at the bottom as well). 

I assume the IRR in this case would include profit/returns from all five of the profit centers of a rental property: cash flow, appreciation, tax benefits, equity paydown, and hedging against inflation? If that's the case, that seems way more dangerous to calculate. For starters, it's a really hard calculation. More importantly, a lot of those numbers would then be pure speculation. If you do the cash-on-cash, that is going to be much more conservative because it just focuses on cash flow. To me, the IRR would be much more deceiving, and dangerous, than cash-on-cash. No contest.

@Tom Shallcross thanks for the info, I read that post and it has some great comments that go along with it. I agree with @Ali Boone that IRR sounds great on the surface but it seems like a lot of speculating to me. And once you start to speculate to much, you'll have a hard time truly trusting the numbers.

I guess the takeaway is to do as much homework as possible and not focus on any one metric as the end-all be-all. Thanks for all of your input guys.

BTW Tom, I'd still be interested in seeing that spreadsheet you mentioned in a previous post. It would give me an idea of what other investors are looking at. Thanks again.