## Cap Rates vs. IRR in Commercial Real Estate Investments

Return metrics explained
Real estate investing is a popular way to build wealth, and commercial real estate is one of the most common investments. Commercial properties are usually multifamily buildings or office buildings, but they can also include retail spaces and even industrial buildings.
If you’re considering investing in commercial real estate, you may be wondering about the difference between cap rates and internal rate of return (IRR). These two metrics are used to evaluate investments in both residential real estate and commercial real estate.

## What is Cap Rate?

A capitalization rate, or cap rate, is an annualized measure of the net operating income (NOI) divided by the property’s investment value. In other words, a cap rate tells you how much cash flow you can expect from a property over a given period of time. It’s calculated by dividing the NOI by the purchase price:

Cap rates help investors compare different properties using common metrics that are easy to understand. For example, if you have two identical properties with different purchase prices but identical NOIs, then their cap rates will be the same regardless of their purchase prices. This makes cap rate analysis more useful than just looking at IRR because it allows investors to compare investments across different markets.

## How to Calculate Cap Rates

Calculating a cap rate involves dividing the net operating income (NOI) by the purchase price, like so:

Cap Rate = NOI / Purchase Price

Net Operating Income = NOI

Purchase Price = P

Cap Rate = NOI / P

For example, if a property has an annual net operating income of \$100,000 and its current market value is \$1 million, then its cap rate would be 10%.

## What is IRR?

The Internal Rate of Return (IRR) is a measure of the profitability of an investment. It tells you what rate of return you would earn if you held onto that investment for one year with no reinvestment risk. It’s calculated by solving for the discount rate that makes your total expected cash flows equal to zero. Here’s how it works:

The discount rate that makes your total expected cash flows equal to zero is called the Internal Rate of Return (IRR). This is how we get a single number representing the profitability of an investment.

## The following example compares two properties with different expected returns:

Property A has a purchase price of \$1 million and a cash flow of \$100,000 per year for five years after that. The expected IRR for this property is 10 percent per year for five years, or 5 percent per year on an annualized basis.

Property B has a purchase price of \$2 million and a cash flow of \$200,000 per year for 20 years after that. The expected IRR for this property is 6 percent per year on an annualized basis.

## How is IRR Calculated?

The internal rate of return (IRR) is a metric used to evaluate the profitability of an investment. It is calculated by discounting the future cash flows of a project back to the present day at an assumed cost of capital. The IRR can then be used to compare different investments and determine which one offers the highest return.

The IRR can be calculated using the following equation:

IRR = Net Present Value / Cost of Capital

## When to Use Cap Rates vs. IRR

Cap rates and internal rates of return (IRR) are two common ways to measure the value of a real estate investment property. Both can be used to compare investments and choose the most profitable ones, but they measure different aspects of the deal.

Cap rates and IRR are both useful metrics to investors. The cap rate is a measure of the return on investment (ROI) that you make when buying an asset. The IRR is the rate at which your investment will return the initial capital invested.

The two metrics are often used together to assess the ROI of a property. Cap rates are calculated by dividing the price per square foot by the annual net operating income (NOI). IRR is calculated by dividing the total amount of cash flow by the total investment amount for an investment property.

Here’s an example: If an investor buys a property for \$150,000 and it generates \$3,000 in annual net operating income, then his cap rate would be around 8%. If he sells this property next year at \$160,000 and makes \$3,200 in NOI, then his IRR would be around 12%.

## Final Thought

Savvy investors are aware of the terms cap rates and IRR, but may not know how to calculate them. The information provided in this article should help prospective real estate investors understand how to calculate both metrics, as well as why they should care, so they can make informed real estate investment decisions.

## #1. Full Form

Cap Rate: Cap rate is the short used for the capitalization rate

IRR: IRR is the short used for internal rate of return

## #2. Definition

Cap rate: A capitalization rate, or cap rate, is an annualized measure of the net operating income (NOI) divided by the property’s investment value. In other words, a cap rate tells you how much cash flow you can expect from a property over a given period of time.

IRR: The Internal Rate of Return (IRR) is a measure of the profitability of an investment. It tells you what rate of return you would earn if you held onto that investment for one year with no reinvestment risk.

## #3. Purpose

Cap Rate: The cap rate is a measure of the return on investment (ROI) that you make when buying an asset.

IRR: The IRR is the rate at which your investment will return the initial capital invested.

## #4. Formula Used for Calculation of cap rate & IRR

Cap Rate: Calculating a cap rate involves dividing the net operating income (NOI) by the purchase price, like so:

Cap Rate = NOI / Purchase Price

IRR: The IRR can be calculated using the following equation

IRR = Net Present Value / Cost of Capital

## #5. Examples

Cap Rate: If a property has an annual net operating income of \$100,000 and its current market value is \$1 million, then its cap rate would be 10%.

IRR: If a Property has a purchase price of \$1 million and a cash flow of \$100,000 per year for five years after that. The expected IRR for this property is 10 percent per year for five years, or 5 percent per year on an annualized basis.

## #6. Pros

Cap rate:

The cap rate is a simple, intuitive metric that allows investors to compare the potential return from one property to another.

It’s easy to calculate: all you need is the purchase price and annual rent to know your cap rate.

IRR:

IRR is a useful tool for evaluating projects with different life spans, or projects that have different cash inflows or outflows at different points in time.