If you’re an active or accredited investor, you may already be very familiar with the concept of cap rate and internal rate of return (IRR), but it’s always good to review the concept no matter what stage of your investment career you’re in. These financial metrics are some of the most commonly used in the commercial real estate investment business. They help measure the profitability of current and potential investments. This article will discuss the nature and value of these concepts in helping you select only the most appropriate, and profitable investments.
What is Cap Rate as it Applies to Accredited Investors?
The capitalization rate at its core is a simple tool to measure the profitability of an investment. It does this by dividing the Annual Net Operating Income (NOI) by the price or value of the property. Cap rates give us an objective measure by which to compare multiple investments. If you’re considering several properties in a particular geographic or class-based market, you can research what is typical and customary. This raises the question: what is typical? The best way to determine the appropriate cap rate is by researching what other investors will accept for a given type of investment. To accomplish this, locate sold and active comparables similar to the project you’re considering and calculate the cap rate. The primary factor that influences the prevailing cap rate is risk. Risk evaluation is a fundamental aspect of investment, real estate, or otherwise.
In general, the greater the risk, the higher the cap rate investors will demand before contributing their capital. Risk factors for real estate investment include property condition, class, vacancy rates, sponsor experience, and market conditions. This is not unique to the investment business, but also an important factor in insurance and lending. Elevated risk doesn’t necessarily mean that an investment isn’t a good choice. Depending on the risk tolerance of the investor, riskier investments can mean higher returns and faster portfolio growth. Risk tolerance varies with the experience of the investor and the amount of liquid capital on hand.
How is IRR Important to Determining Profitability?
IRR is another important metric for comparing investment opportunities. This metric requires a more sophisticated calculation that considers the time value of money and the rate of return the investment provides over the projected term of the investment. The calculated IRR for an investment is the discount rate that brings the net present value to zero. This is abstract but helps determine the overall growth rate that the project is likely to provide considering the capital invested, the number of time periods, and the amount of cash flow during each period.
The advantage of IRR, or its usefulness as a supplement to the cap rate, is that it incorporates the term of the investment and allows you to anticipate the overall rate of return. This is important when you’re evaluating short-term investments, or those that have a fixed period and projected exit strategy. For smaller residential investments and those held indefinitely, the cap rate may suffice. Where you know the amount of capital invested, and the income is projected to change over the term of the investment, IRR is beneficial to calculate. In addition, the due-diligence effort provides greater confidence in selecting a high-value investment.
Why internal, and not external rate of return? The ‘internal’ refers to the fact that this metric doesn’t consider external factors such as the rate of capital reinvestment and the cost of funds. For more accurate measurements that include these factors, the modified internal rate of return (MIRR) is useful. The MIRR accounts for the fact that capital is typically not reinvested at the project’s rate of return. To provide a more accurate idea of the return, the MIRR uses the cost of capital as the rate of reinvestment.
Considering Risk in Determining a Cap Rate and IRR
It’s a bad idea to put money into any investment, regardless of risk, if losing the funds will have a negative effect on your solvency. This is why the SEC insists that only accredited investors participate in certain types of investments. Another thing to consider are your overall objectives as an investor. Are you investing to generate dividends and cash flow to earn a living? To build your portfolio to provide enhanced net worth and cash flow for retirement? How close are you to retirement? If you’re looking to make a living off your investments, and you have sufficient liquidity, you can pursue a riskier strategy in short-term projects that will generate higher return. When you’re investing for the long-term, low risk, stable investments can be a better option.
Gauging the risk associated with high-value investments can be a daunting task, but when you have a team of experienced professionals supporting you, calculating and evaluating IRR and cap rates is much simpler. Connect with us to learn more about how we can help you in finding only the most suitable investment opportunities. Partnering in crowdfunding projects offers the lowest risk profile and the highest potential returns, as well as the least stress.