One focuses on cash flow, but the other on total investment return.
There are a handful of popular return metrics for commercial real estate investment.
You have Equity Multiple, expressed as a ratio, that tells you how much money you’ll end up with compared to how much you started with. So an equity multiple of “2.5x” would mean you get $2.50 out by putting $1.00 in. Simple, easy to understand, BUT, it doesn’t tell you how long it takes to get that return. I’m sure you’d rather take $2.50 back tomorrow, rather than in 10 years. Inflation will happen in that time, and the $2.50 will be worth less.
Two of the most popular return metrics are IRR and Cash on Cash Return. Unlike Equity Multiple, there’s a time component to these, so they are expressed as a percentage, which means your percentage return per year.
But IRR and Cash on Cash Return tell an investor two very different things about their return. Let’s dive in.
IRR stands for Internal Rate of Return. As a financial metric, it measures the total return on an investment, weighting cash returned sooner more heavily than cash returned later according to the time value of money. This is an institutional-style return metric which helps major funds account for gains.
Having a high IRR does not mean you are seeing any current cash flow. It takes the final sale/exit of an asset into account, in addition to the cash flows you receive throughout the life of the investment.
Cash on Cash tells you the current return on an investment. You calculate it by taking the cash returned on the asset in a given year, divided by the total cash outlay it took to get that return. Cash on Cash Return can change each year based on the performance of an asset, but real estate investors usually talk about Cash on Cash Return as a single metric when as asset is stabilized (when it reaches stable cash flow). If an investor purchases a property for $1 Million (no debt in this example), and in the third year of ownership the net cash flow was $100,000, we’d say that this is a 10% Cash on Cash Return ($100k divided by $1 Million). In the second or the fourth year, the Cash on Cash Return may be different — it’s a spot metric for a given year.
So which of these measures is right to use when picking a commercial real estate investment? Both. A savvy investor calculates both return metrics, and balances them against their own return priority, which is different for different investors with different financial situations. A retiree looking to live off the income generated by a property may be very focused on the Cash on Cash Return of potential investments, while a young entrepreneur may realize that their game is longer, suggesting a bias toward IRR.
The more patient your capital is, the more you should consider IRR the most important metric.
Every investor should think about their objective when planning a strategy and setting return metric goals.