When reading about commercial real estate investments you will see many potential investment returns expressed as an IRR. The IRR is the average annual return an investor can expect to receive over a certain amount of time, given a corresponding amount of cash flows. In this post we'll explore what IRR can tell us about a real estate investment.
Three real estate metrics or expressions of Return On Investment investors may encounter today include IRR, cap rate and cash on cash yields.
IRR refers to Internal Rate of Return. Simply put IRR refers to the average annual return over a specific number of years. For example; a retail center property investor would determine the IRR of a specific opportunity by calculating the net cash flow from operating the property and appreciation growth expected for the period a property will be held.
The 'Cap' or capitalization rate is a calculation frequently used in commercial real estate, and now also on portfolios of single-family home rental properties. Cap rate offers a quick way to compare investment opportunities. Simply stated it is the annual net income divided by the cost or value of the property.
For example a property being purchased for $1M, which produces $100k in net annual income delivers a 10% cap rate. The pitfall here is for investors with properties that have appreciated significantly over time. Using the original purchase price or cash paid of $200k for a property yielding $100k in net income an investor may believe they are receiving a 50% cap rate. However, if the property is now actually worth $1M, the true current cap rate given lost opportunity costs is only 10%.
This real estate metric quickly tells an investor what annual return they can expect to receive in cash flow before taxes, based upon their actual cash investment. This is differentiated from cap rate which often considers the value or cost of the entire property (i.e. both the cash investment plus any debt placed on the property).
For example; an investor putting $300,000 into a deal and receiving pay outs of $60,000 a year (before taxes) has a cash on cash yield of 20%. Appreciation is not included in the cash on cash yield calculation and could actually result in a higher overall return on investment. Be sure not to calculate any return of investment in this calculation as it is not profit.
We know that in order to calculate the IRR, we need the yearly cash flows our investment property is expected to produce. The cash flows, of course, can be partitioned into two categories:
Once we know these, we can easily compute IRR with a handy-dandy financial calculator, or using Excel. The IRR partition lets the investor know the weights of the IRR calculation. Simply put, we can determine how much of our IRR is coming from our rental income, and how much of it is coming from our projected sales price. Let's dive into it.
Partitioning the IRR is a 4–step process:
Let's assume an investment property cost us $2,000,000 and would produce $250,000 in cash flows for 5 years, at which point we would sell it for $2,750,000.
These cash flows would allow the property to realize an IRR of 17.77% (not bad!). In order to determine how much of the IRR is attributable to the Cash Flow from Rent and how much of it is attributable to the projected Cash Flow from Sale, we need to calculate the present value of the cash flows. In other words, we want the dollars that we are receiving in future years to be stated in present day dollars. We can do this by using our IRR of 17.77% as the discount rate.
| Year | Cash Flow from Rent | Present Value |
|---|---|---|
| 1 | $250,000 | $212,286 |
| 2 | $250,000 | $180,261 |
| 3 | $250,000 | $153,067 |
| 4 | $250,000 | $129,975 |
| 5 | $250,000 | $110,368 |
| Cash Flow from Sale | ||
| 5 | $2,750,000 | $1,214,044 |
| Total PV | $2,000,000 |
As the table shows, the sum of the total PV of the Cash Flow from Rent is $785,956 while the sum of the total PV of the Cash Flow from Sale is $1,214,044. This gives us a total PV of $2,000,000, which we can now use to help us complete steps 3 and 4 of our IRR partitioning:
For step 3, take $785,956 ÷ $2,000,000 = 39.30%
For step 4, take $1,214,044 ÷ $2,000,000 = 60.70%
There we have it! We now know that 39.30% of our IRR stems from our Cash Flow from Rent and 60.70% of our IRR is attributable to our projected Cash Flow from Sale. Now what can we infer from these proportions?
Investors are more certain in projecting cash flows that will stem from their existing leases. There is more uncertainty surrounding the projected cash flow from sale, given that in most cases, it will depend on a forward NOI and an assumed Cap Rate. The value of the partitioned IRR lies in its separation of the more certain cash flow (rent roll) and the less certain cash flow (projected sale). Our hypothetical investment yielded an IRR of 17.77%, of which 39.30% was attributable to our Cash Flow from Rent. If there was an alternative investment with the same IRR of 17.77%, but only 15% of the IRR was attributable to Cash Flow from Rent, we can infer that more risk is associated with the alternative investment as 85% of the IRR depends on the projected Cash Flow from Sale.
Making the final investment decision should not depend solely on a return statistic. It's instructive to see what the return is actually composed of. Partitioning the IRR allows us to do this – it gives us the details needed to see the big picture.