Cash on Cash and IRR Explained
In the world of commercial real estate investing, there are certain terms that are used when discussing how viable an investment property may be. Two of those terms, cash on cash return and internal rate of return are both ways that commercial real estate investors, particularly those who are considering investing in a real estate syndication decide how sound the investment is. If you’re considering getting into the world of commercial real estate investing, you should gain at least a working understanding of what these terms mean. Being educated on cash-on-cash returns and IRR returns is even more important if you plan on pursuing passive real estate investing.
What is Cash on Cash Return?
Investors use cash on cash return to figure out the current return on an investment. Essentially, cash on cash return, or CoC return is the relationship between the initial investment in a property and its cash flow. In order to determine a property’s cash on cash return, you divide the initial investment by the property’s cashflow.
For example, let’s say that you purchase a property that costs $1 million. For the sake of this example, we’re going to say that you paid cash for that $1 million property so there is no debt to figure into our calculations. In the second year of your ownership on this property, it generates $100,000. Based on the formula for determining a property’s CoC return, that property has a 10% CoC return. While other metrics are used to measure the long-term viability of an investment, the CoC return of a property simply gives a percentage of how well the property has performed in a given year.
What is Internal Rate of Return?
The other most commonly used metric when discussing commercial real estate investments is internal rate of return, or IRR. Unlike the CoC returns. Internal rate of returns also account for the time value of money when evaluating a property’s performance. An IRR is an institutional metric that major funds use to account for gains.
The complex nature of figuring out a property’s IRR makes it more difficult to calculate. Fortunately, there is an IRR function in Excel that allows you to plug in the numbers and let the system give you a solution to the equation. The technical definition of IRR is the interest rate that is used to make the net present value of all cash flow zero. If that sounds confusing to you, don’t get frustrated. It’s a long, variable-filled equation that even seasoned investors often struggle with. While CoC simply looks at how much money a property generates in a given year and compares that number to the initial investment as a percentage, IRR considers the initial investment, interest, the sale price of a property and more.
Which One Should I Use?
The key to being successful as a real estate investor is to be as educated as you can possibly be about any property that you’re considering investing in. Just like you would want to review comparable sales nd other market data if you were investing in a fix and flip residential property, you should take a look at both the CoC and IRR of any commercial property that you’re considering as an investment. The data that you collect ensures that you know if an investment is viable for you and can also help you decide if and when you need to sell an investment property based on your own personal goals as an investor. That information varies based on your financial assets, short-term goals for the property, long-term goals as an investor and your risk tolerance. The best way to ensure your success as a real estate investor is to be as educated about every potential investment as you can be. That information puts you in a better position to diversify your portfolio, amass personal net-worth quicker and create a lasting legacy of financial success.