Investors and property owners use two general rates to understand the earning potential of a property. The capitalization rate (CAP rate) and the Internal Rate of Return (IRR). It’s critically important to understand the two rates and how to calculate them when considering property investment in commercial real estate.
Cap rate is determined by dividing the net operating income (NOI) by the purchase price. The cap rate will be as accurate as the information you have for the actual NOI. This is where doing your due diligence to find out all of the income and operating expenses is of utmost importance. your cap rate will quickly be eaten away by any operating expenses that are not factored in. Here is an example using simple math of an office building with a 1 million dollar purchase price that has NOI of 100k annually
$100,000 / 1,000,000 = .10 or 10%
If these above numbers are true, this would be a 10 Cap.
When pulling your data to find a cap rate at a commercial property, make sure you are aware of the leases that are currently in place. This will help you understand the accuracy of your future NOI should tenants be replaced and a different lease structure is implemented for the new tenant.
The cap rate will help you quickly understand if an investment property will meet your criteria and it will be helpful to the lender who is assessing the level of risk associated with the property. When considering risk, the lender will consider market risk (property type, stage in the cycle for that market, specific metro area) and property-specific risk (what capital improvements are needed, current cash flow, etc.). These considerations will all factored into the loan and interest rate offered to you on the property.
Internal Rate Of Return
While the cap rate is a good metric to understand the expected return when you are purchasing the property, the IRR will give you a projection of the full investment return over the entire holding period. IRR is the annualized yield on income generated or capable of being generated with the investment opportunity. While a higher cap rate is good to see at purchase, it’s better to see a higher IRR at exit.
Let’s use our same office building example from above and add some data to it. We purchased the office building for 1MM dollars and the annual income is 100k. Now let’s also suppose we held the property for five years and purchase it with 60% leverage on a 25-year term. At year five we were able to sell the property at a 5 CAP for 2MM dollars. This means that our out of pocket cost at the time of purchase was $400,000 and our annual debt service on the 600k loan will be $24000. IRR is an advanced technique but can be simplified using a spreadsheet like the one below:
In year one we place our purchase price, the loan proceeds, and our out of pocket cost. In years two through five, we place the annual income and deduct the annual debt service. At year five, in addition to the annual income and debt service, we also add the loan repayment and the sale price and plug that into the excel formula. You’ll see in this example that we have an extremely healthy IRR of 41.27%. You’ll also notice that we have an equity multiple of 4.45x. This is simply calculated by taking the money out divided by the money in to understand how many times multiple of your original investment have been achieved.
The example that we just reviewed, even though it’s hypothetical, it uses actual numbers. When you are going into an investment, you will be working on pro-forma data, so you cannot guarantee the accuracy of the IRR. This is why having a business plan that you can execute is so crucial to your business. If you can calculate an IRR that makes sense using conservative numbers, then you can enter the opportunity with confidence that you will meet and potentially exceed your investment goals. Make sure the IRR makes sense against other investment options in the marketplace. If there is a low to no risk security that returns 6-7%, there may not be value in a riskier investment unless the returns are much higher.
To give a general idea of where IRR is typically projected on a commercial real estate deal:
Garbage in, Garbage Out
Both metrics have the same downfall: they’re only as good as the information you put into them. A cap rate will tell you what the returns were for a given period. IRRs are future projections of the project’s complete performance. Either way, if your cap rate or irr calculation data is incorrect, your projections will be incorrect. Don’t start your real estate investment on the wrong foot. Make sure that you are entering data that is as accurate as it can be so that your projected return on investment can be trusted as you move forward with an investment.
If you have any questions regarding the real estate investing industry, the team at First National Realty Partners is just a phone call away. We’re here to answer your questions and provide guidance about your investment opportunities. If you would like to know more about the benefits of private equity commercial real estate investing, please don’t hesitate to reach out. Our team is built with the best industry leaders, utilizing proven strategies that create great investment opportunities for you. Contact us any time when you are ready to learn more about the possibilities of investing in commercial real estate.
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