Real Estate Pro Forma Return Metrics

A common question when attempting to value a commercial real estate deal is “What return metric should I use?” Common metrics include, Cap Rate, Cash on Cash and IRR. All of these Broker License Definition metrics approximate an annual percentage return you will receive on your investment. Which metric is the most useful? Let’s first look at how each metric is calculated.
The cap rate is a real industry term which is determined by dividing the net operating income of your property by the purchase price of your property. So, if you bought a property for one million dollars and in the first year your net operating income was one hundred thousand dollars, then your cap rate would be ten percent or you would say that you bought the property at a ten cap. Cap rates are also used to approximate the price you would pay for a building. Riskier investments require higher returns, so that a riskier property would require a higher cap rate from an investor. A safer property would be purchased at a lower cap.
Cash on Cash is an industry term that is determined by dividing the investor’s cash flow of a particular operating year with the amount of equity or cash the investor has invested. So, if an investor put up one hundred thousand dollars of equity to purchase a property and in the first year he or she received eight thousand dollars in cash flow after all expenses and debt service, then the investor’s cash on cash return for the period was eight percent. Another derivative of cash on cash is called cash on cost. Instead of the equity investment, this metric uses the cost of building or renovating a building and the associated cash flows that the investment will generate.
IRR is a general finance term that is commonly used in commercial real estate. IRR stands for internal rate of return and is calculated by using all the cash flows an investor will make (positive and negative) over the course of the investment period. IRR represents the average annual yield the investor will realize over that time period.
What are the differences between these return metrics? Cap Rates are usually used in analyzing the purchase and sale of properties. They only look at the transaction event in that specific time period and do not look at the entire string of cash flows. Cap Rate is a good way to get Real Estate Marketing Ideas For Social Media a quick judge of how a particular property is being valued. Cash on cash looks at the individual cash flow periods and does not look at appreciation of the asset upon exit. IRR looks at the entire cash flow of the investor and is a more exact approach to valuing an investment.

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