One of the most frequently asked questions in real estate investing is, what sort of returns will I get? That is, before committing their cash to a deal, investors will want a clear sense of the amount they can expect that cash to grow. However, a variety of techniques exist to measure returns. In commercial real estate, two of the most common investment return measures are a deal’s 1) cash on cash returns, and 2) internal rate of return, or IRR. Both have their pros and cons, so we’ll use this article to discuss cash on cash vs IRR.
Specifically, we’ll cover the following topics:
- Return and Why it Matters
- Cash on Cash
- IRR
- Final Thoughts on Cash on Cash vs IRR
Return and Why it Matters
Conceptually, return represents how much money you made (or lost) on an investment over a given time period. For instance, say you bought a stock for $10 and then sold it at some later date for $20. You “made” $10 on this investment, right?
Not so fast!
What if, during the time you held the stock, inflation was rampant? The $10 you made in the future isn’t worth as much as the $10 you originally invested. Or, does this $10 return account for taxes? Depending on the hold period, you likely need to pay short- or long-term capital gains taxes. What if, while holding that stock, another investment opportunity would have resulted in you making $20 instead of $10? In that case, you could say you actually lost $10 due to the opportunity cost.
Bottom line, measuring a deal’s returns isn’t as straightforward as it may seem. A variety of techniques exist to determine the success – or failure – of an investment. In real estate, investors frequently use two measures: cash on cash and internal rate of return, or IRR. We’ll provide an overview of both in the following sections.
Cash on Cash
Cash on Cash Defined
Cash on cash, as the name suggests, measures a deal’s returns based on how much cash it generates relative to the initial investment. However, it’s important to note that this tool only measures cash returns in a single period – not over the entire hold period.
Example
Say that someone offers you the opportunity to invest in an apartment building. You contribute $100,000 and receive a 10% stake in the deal. But, before committing, you – quite understandably – want to analyze the deal’s expected returns.
According to the deal sponsor’s projected numbers, the apartment building will generate $50,000 in cash distributions during the first year. At a 10% stake, you will receive $5,000 of that. Cash on cash equals a single year’s cash divided by the total investment. As a result, your first year cash on cash return would equal 5% ($5,000 distribution divided by $100,000 investment).
Pros and Cons
The major advantage to the cash on cash method is simplicity. You don’t need an accounting or finance background to understand conceptually what this metric means. For instance, if a savings deposit account offers 2% and a real estate investment offers 5% cash on cash, it’s clear that the real estate option generates more cash than the savings account.
However, this simplicity relates directly to the drawbacks of cash on cash as a deal analysis metric. Due to the fact that it only accounts for a single year, cash on cash doesn’t tell investors about a deal’s total returns. Sure, 5% cash on cash in the first year may seem great, but what sort of returns will you see over the life of the deal?
Unfortunately, cash on cash doesn’t account for total cash flows (both distributions and the ultimate sale of the property). Furthermore, it doesn’t include any time-value-of-money considerations. Inflation leads to future dollars being worth less than current dollars. So, if you project third year cash on cash returns of 6%, that fails to account for the fact that those dollars are actually worth less than your initial investment dollars, meaning the effective cash on cash return would be less than 6%.
IRR
IRR Defined
IRR addresses the above shortcomings of cash on cash as an investment analysis metric. But, to understand this tool, investors need to have a solid grasp of the time value of money. When you invest money, it grows over time. But, the question investors need to answer is how much did this money grow over time? Phrased differently, if you will have $100,000 in the future, what’s the equivalent amount in the present?
IRR answers these questions. Conceptually, IRR gives investors the annualized growth rate where the initial cash investment equals the present value of all future cash flows. In other words, IRR converts all of a deal’s cash flows into present dollars, allowing investors to account for both a deal’s total cash flows and the time value of money.
Example
Let’s use the same apartment example. But, now we’ll incorporate all of the deal’s cash flows – not just the first year. Assume that in years one through four you’re projected to receive $5,000. Then, in year five, the building will be sold, and your piece of the sales proceeds will be $200,000:
| Year | Cash |
| 0 | -$100,000.00 |
| 1 | $5,000.00 |
| 2 | $5,000.00 |
| 3 | $5,000.00 |
| 4 | $5,000.00 |
| 5 | $200,000.00 |
The question becomes, if we convert the future cash flows into the first year dollars, what sort of returns does this deal generate? While the actual calculations to solve for IRR are complicated, the Excel formula =irr() makes solving this straightforward. Using this technique, the above deal results in an 18.2% IRR. That is, 18.2% is the interest rate where the present value of all future cash flows equals the initial cash investment. In other words, over the life of the deal, you would command an annualized rate of return of 18.2%.
Pros and Cons
The major drawback to IRR is its complexity. Time value of money can be a confusing concept, and not all investors will have a thorough grasp.
But, this added complexity results in a far more comprehensive metric. Rather than assess a single year’s cash flow, IRR gives investors a deal’s total returns. Furthermore, it inherently accounts for the fact that dollars are worth more now than they are in the future. As such, even if an investor may not fully understand the calculations behind IRR, most people will grasp the benefit of measuring a deal’s total returns.
Final Thoughts on Cash on Cash vs IRR
After considering the above background, investors shouldn’t ask about cash on cash versus IRR. Rather, they should measure any potential deal using both techniques. Each metric plays a specific role in analyzing a deal, so savvy investors will want a solid understanding of cash on cash returns and IRR.
If you’d like to discuss different real estate investing options for your unique situation, we’d love to chat! Drop us a note, and we’ll set up a meeting to talk about available passive real estate investment opportunities – and the associated returns!