Investing in commercial real estate is a balancing act of evaluating risks and benefits before diving into a potential investment. There are many details that shape investment and it is important to analyze a potential investment those details to fully understand what you may be getting into. Two important factors we use to evaluate a property’s value are cap rate and internal rate of return (IRR). Let’s dive in.
What is a Cap Rate?
A cap rate (or formally, capitalization rate) is a formula, investors use to estimate the return they can make on a property. This rate is calculated by dividing the net operating income (NOI) by the purchase price.
Cap rates can be used to compare different investment opportunities. A high cap rate indicates a low value, and the lower the cap rate, the higher the value.
It’s important to note that debt is not included in cap rate calculation. This is valuable because it allows you to compare investment opportunities without getting bogged down by financing. This lets you look at the potential value of a property and compare it with others in a simplified way.
Several factors can affect cap rates:
-Economics and demographics
How does economics/demographics affect cap rate?
If you purchase a property in a big city such as Chicago or DC, you are looking at a strong economy. There will be high demand for properties in major metropolitan areas because real estate buyers are always interested in investing there.
High demand affects real estate values in these areas in a positive way and thus less risky for investors. Chicago and DC and other similar cities have low cap rates and less perceived risk.
On the other hand, rural markets are different. They aren’t as strong economically as big cities so their cap rates are expected to be higher as it is riskier to invest in a property located in those rural locations.
This is how we can use cap rates to compare different markets, but you can take it a step further and use cap rates to compare different properties in the same market.
How do local markets affect cap rate?
In the same market, some locations are better than others. Commercial real estate buildings are organized into Class A, Class B, Class C, and Class D based on location and condition.
Class A means a property is in the best location and condition, and thus more in-demand. Class B through D are progressively less desirable.
As you move through the property classes, the cap rates increase for the lower classes. These are the property types still worth investing in, but you should understand the risks in order to make an educated decision on what class of property to invest in.
How does property type affect cap rate?
Residential properties come with a different set of risks and benefits than commercial properties. The difference is that even if the economy is worsening, people will still need a place to live. This means that residential properties are typically less risky than commercial properties.
Many aspects go into cap rate, and this is information you can calculate and use to pick a market or a property type, set goals for investments, and make decisions about selling a property you already own or purchasing one. Understanding the cap rate gives you access to more information you can use to make wise financial decisions.
Now let’s dive into IRR.
What is the internal rate of return?
Internal rate of return in a way to value an opportunity by predicting what an investor will make on an investment. IRR takes into account changes in income, property value, and debt service, and expresses returns on a project on an annualized basis. IRR describes future cash flow and profit to be made.
How do you determine IRR?
To determine the internal rate of return, you need to know the yearly potential cash flows of the property. Cash flow includes rent and money from the sale of the property.
Predicting future cash flows is complicated and this is important to note.
The sooner the earnings from an investment are received, the higher the IRR will be. A higher IRR doesn’t necessarily ensure a better investment, it could mean the same cash flow but earlier. Also important to note that IRR calculations do not consider risk profile and other variables that may impact returns.
Why is IRR important?
The internal rate of return can be analyzed alongside cap rates because they provide different information. IRR takes into account cash flow after debt and other expenses and thus tells us a more complete story.
Investors use IRR to compare investment opportunities using the economic concept of time value and money. This emphasizes that a dollar today is worth more than a dollar tomorrow because of inflation and risk.
Should I use Cap Rate or IRR?
There are different situations you would want to use cap rates vs IRR. IRR is most valuable when looking at short and medium-term investments, or investments with a fixed period and projected exit plan.
Smaller investments like two or three-family home investments allow the simple use of a cap rate, but bigger investments like apartment buildings should calculate a projected IRR and use a cap rate.
Cap rates provide a glimpse at the value of a property at a given moment in time, but IRR provides a wider scope view of the total returns on an investment. Both tools have their limits which is why the more information you have access to, the better it is.