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Evaluating a potential real estate investment is no easy task, and there are a number of things for investors to consider.

Two of the metrics commonly used are the capitalization rate (both at purchase and estimated at sale), and the internal rate of return (IRR) objective. Both measures can be useful evaluation tools, but it’s important to understand exactly what they measure and why they’re important.

Capitalization Rate

The capitalization rate (“cap rate”) is a simple valuation ratio that is determined by dividing the property’s net operating income (“NOI”) by the property’s then-current market value, with the final number expressed as a percentage.

In general, higher cap rates usually indicate a more favorable valuation (for a buyer), and potentially a higher expected return from that property’s cash flow.

A property’s NOI is generally its annual revenue less its operating costs; these include utilities, maintenance, management and leasing fees, and personnel costs. Expenses related to capital improvements and depreciation are generally not calculated as part of NOI, since these are either extraordinary or non-cash expenses.

A property that’s valued at $1 million and has an NOI of $100,000, for example, would have a cap rate of 10%, while a property that’s valued at $500,000 with an NOI of $25,000 would have a cap rate of 5%. In general, higher cap rates usually indicate a more favorable valuation (for a buyer), and potentially a higher expected return from that property’s cash flow.

The cap rate is useful as a basic valuation measure for a certain point in time, since an investor can see how a property’s valuation compares to similar properties — but it has its limitations.

The overall investment prospects for a property depend on the future growth of the property’s income, and on changes in local property values – and cap rates take no account of these factors. Cap rates also don’t factor in the effects of the property’s financing terms. Still, an analysis of cap rates is a good first step on the road to reaching an investment decision.

Internal Rate of Return

Like the cap rate, an internal rate of return (IRR) objective is expressed as a percentage, but importantly it also takes into account the time value of money.

Both cap rates and IRRs can play an important part in making investment decisions, but each of those measures are only as accurate as the information that’s used to calculate them.

The IRR is similar to the concept of “net present value,” and measures, as a percentage, the return rate earned on an investment during a specific time frame, assuming a reinvestment of cash flows at the same return rate.

For example, the IRR on a 5-year investment would assume that the first year’s income also itself earns returns during the remaining four years. As a practical matter, some income is usually withdrawn from the investment over the course of time, but the IRR provides a good way to measure apples to apples.

The IRR is a more robust tool than the cap rate because, instead of focusing on a single moment in time, the IRR factors in more than just the NOI and purchase price – it also considers financing expenses and NOI objectives, and the value of various factors in view of the timing of the cash inflows and outflows.

IRR analysis is also more robust in allowing investors to consider changing operating or exit assumptions over time. It can also be calculated with and without estimated taxes so that an investor can estimate his effective tax rate for various periods.

Using Cap Rate and IRR Appropriately

A property’s cap rate can be a straightforward way to estimate value (or comparative value) when buying or selling a property. Single-tenant properties with a long-term lease also lend themselves to simple cap rate valuations, since a constant income may make it easier to calculate annual operating expenses.

The IRR is a more robust tool than the cap rate because, instead of focusing on a single moment in time, the IRR accounts for the full life cycle of the investment. Still, an analysis of cap rates is a good first step on the road to reaching an investment decision.

With most multi-tenant assets, however, it’s important to make assumptions about the likely cash flows over the life of the investment.

If a property’s rents are expected to increase over time, or the operating expenses are likely to creep up, those assumptions can be factored into the IRR calculation. At the same time, these assumptions are thus critically important, and an IRR calculation is only useful if the underlying assumptions are reasonable ones. Nevertheless, the IRR is a more comprehensive method for evaluating the overall investment prospects for a property.

Tools to be Used With Caution

Neither the cap rate nor the IRR is without limitations.

Cap rates don’t take into account financing costs or changes in operating income, while IRRs are inherently dependent upon the assumptions made in estimating those future factors. Unforeseen expenses, changes in vacancy rates, and other factors also affect investment returns and are difficult to predict with accuracy.

Both cap rates and IRRs can play an important part in making investment decisions, but each of those measures are only as accurate as the information that’s used to calculate them.

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