Internal Rate of Return (IRR) vs. Cash Yield: What’s The Difference?
When it comes to evaluating the potential of a commercial real estate investment, investors rely on various financial metrics to calculate the overall ROI. Among the myriad of data points available, there’s two that stand out as key indicators of profitability: Internal Rate of Return (IRR) and Cash-on-Cash Return.
In this blog post, we’ll provide context on each of these metrics, explain how they’re calculated, and discuss why they matter for commercial real estate investors.
Internal Rate of Return (IRR)
IRR is a metric used to calculate the annualized rate of return an investor can expect to earn over the holding period of an investment. It considers the timing and amount of both cash inflows and outflows, making it a comprehensive metric for assessing the overall performance of an investment.
How it’s calculated:
Initially, an investor estimates the property’s future cash flows, taking into account rental income, operating expenses, financing costs, and potential sales proceeds. These projections are then discounted back to their present values using the IRR as the discount rate. The IRR is the rate at which the net present value (NPV) of these cash flows equals zero. To find this rate, real estate professionals often use specialized financial software that can perform the necessary iterative calculations efficiently. The resulting IRR percentage provides investors with a clear measure of the property’s potential return on investment.
Why it matters:
The IRR holds immense significance in commercial real estate for several compelling reasons: 1) It accounts for the time value of money, recognizing that a dollar earned today is worth more than a dollar earned in the future, 2) IRR allows investors to gauge the potential risk associated with the investment, as a higher IRR typically indicates a shorter payback period and, therefore, a quicker return on investment, and 3) IRR can help investors evaluate the cost of borrowing versus the expected return on the investment.
Cash-on-cash return, oftentimes referred to as cash yield, focuses on the annual cash flow generated by an investment relative to the initial cash investment. It provides a straightforward way to evaluate how much income an investor can expect to receive on their invested capital each year.
How it’s calculated:
Cash-on-cash is a much simpler calculation that is found by dividing the property’s annual pre-tax cash flow, which includes rental income minus operating expenses, by the initial cash investment made by the investor. This initial investment typically encompasses the down payment, closing costs, and any immediate renovation or acquisition expenses. The resulting percentage represents the annual return on the actual cash invested in the property.
Why it matters:
Similar to IRR, cash-on-cash return is vital for commercial real estate investors because it gauges profitability and risk. It’s a quick and clear measure of how efficiently invested capital generates income by providing a snapshot of what the investor can expect to make over the course of a single year.
Which metric to focus on entirely depends on your preference as an investor. As you can see, they’re similar in nature, but the biggest differentiating factor is time. If you appreciate a holistic perspective to grasp the overall projected return, you’ll probably lean towards IRR. On the other hand, certain investors prioritize comprehending their annual returns, making them more inclined towards cash-on-cash, which also boasts the advantage of being straightforward to calculate.
It’s important to note that both return metrics are subjective and based on the strategy of the sponsor and their partners. At Excelsior Capital, our investment strategy primarily centers around two asset classes: flex industrial and medical office. Our focus on these two asset classes is due to certain fundamental real estate and demographic trends that we firmly believe will persist for the foreseeable future, and this strategy has delivered consistently strong returns for our investors.
If you’re interested in learning more, please feel free to contact us or set up a call with a member of our acquisitions team!
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