When it comes to rental property analysis, real estate investors often come across different real estate metrics that are useful to evaluate the performance of their investments or to compare the profitability of potential real estate investments. Internal rate of return and cash on cash return are two different metrics that are commonly used, but what is the difference between these rates? And how do you use them to make money in real estate? Read this blog for everything you need to know about internal rate of return and cash on cash return.
Internal Rate of Return: Definition
IRR is a widely used investment performance measure in real estate, yet it’s also largely misunderstood. In finance terms, internal rate of return is the discount rate at which the net present value of future cash flows of an investment is equal to zero. Therefore, calculating IRR relies on the same formula as the net present value (NPV) does. In more simple terms, the internal rate of return is the rate at which a real estate investment grows (or shrinks). Effectively, IRR represents the percentage rate earned on each dollar invested over the entire period of investment (holding the real estate property).
For example, if an investment property was purchased to be rented out for 10 years, interest on the rental income received during the first year is earned for the remaining 9 years. For the second year, interest is earned for the next 8 years; consequently, each year would earn more interest. The sum of the interest earned over the period of 10 years is what we call internal rate of return
How to Calculate Internal Rate of Return
As mentioned earlier, IRR of a real estate investment is typically associated with another real estate metric – NPV. The NPV of a rental property is calculated using the following formula – to calculate IRR, you would set NPV equal to zero and solve for IRR.
NPV = (C1/(1+R)^1)+ (C2/(1+R)^2)+…+(Cn/(1+R)^n) – C0
C0: Total initial investment costs
C1: Estimated cash flow of year 1
C2: Estimated cash flow of year 2
Cn: Estimated cash flow of year n; when the investment property is sold. This cash flow includes sale proceeds.
R: Discount rate %
To calculate IRR, the formula would look like this:
0-= (C1/(1+IRR)^1)+ (C2/(1+IRR)^2)+…+(Cn/(1+R)^n) – C0
Trying to solve this equation by hand is difficult. You can use the trial and error method until you find what IRR makes the equation equal to zero. Otherwise, you can opt for different real estate investment tools or simply use the excel command IRR() to solve the equation.
What Is a Good Internal Rate of Return?
You would think that a higher internal rate of return is better. However, one of the problems of using IRR to evaluate investment performance is that it can be misleading if used alone. A bigger IRR might indeed look good but it is important that real estate investors look beyond the surface and use IRR in conjunction with other property metrics like cash on cash return when performing rental property analysis.
Cash on Cash Return: Definition
Cash on cash return is another important rate of return used to evaluate a real estate investment’s performance. Cash on cash return calculates the cash income earned on cash invested in a real estate property. In other words, CoC return provides a more accurate analysis of an investment’s performance when compared with the standard return on investment (ROI).
Using cash on cash return to evaluate an investment’s performance has its pros and cons. While this metric provides a quick and easy way to compare different investment opportunities or evaluate a real estate investment, it doesn’t give the full picture when used beyond year 1 of the investment as it does not consider the time value of money and property appreciation.
How to Calculate Cash on Cash Return
Cash on cash return analysis is usually used for investment properties that involve long-term debt borrowing, since it gives a more accurate analysis on the return on cash invested. CoC return is calculated using the following formula:
Cash on cash return formula = Net operating income (NOI) / Cash invested
Cash on cash return calculation example:
Property value = $250,000
Down payment = $50,000
Yearly mortgage payment = $15,000 (for a long term 30-year loan at 5% interest rate)
Yearly rent = $2,500 x 12 = $30,000
Operating expenses = $5000
NOI = $30,000 – $5000 = $25,000
Cash on cash return = ($25,000-$15,000)/$50,000 = 20%
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What Is a Good Cash on Cash Return?
Real estate experts disagree on the exact numbers of what a good cash on cash return for real estate investment is. For some, a CoC return between 8-12% is considered “good”, while others expect a cash on cash return no less than 20%. The answer to this question is subjective and varies from one investment property to another.
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Cash on Cash Return vs. Internal Rate of Return
Cash on cash return is a simple and straightforward method to calculate return on investments that involve long-term debt borrowing. On the other hand, calculating the internal rate of return is more complicated because it requires you to project future cash flows of the investment, including the sale of the investment at the end of the holding period. The main advantage of IRR when compared to cash on cash return is that it includes the money value of time and property appreciation, a limitation that makes the use of CoC return not so accurate beyond year 1 of investment.
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