What is the Difference Between Internal Rate of Return (IRR) & Return on Investment (ROI)?
While most people will say that IRR is more complex and harder to calculate than ROI, the primary difference really has to do with the fact that IRR takes into account the time value of money (TVM) while ROI does not. Imagine a project with a total ROI of 17%. This could be great if the investment was only for one year but how great is it if the investment is over a 7 year period? Simply relying on ROI as a single metric would not take into account the length of time of the investment. Conversely, IRR does take into consideration both the amount and the timing of the return, which allows for a more precise evaluation of the potential performance of a given investment. To summarize:
Advantages of IRR
- Time Value of Money – The timing of all future cash flows are considered; therefore, each cash flow is given an appropriate weight by discounting the time value of money.
- Simplicity – IRR is an easy metric to calculate and it provides a simple means by which to compare various real estate projects.
- Hurdle Rate Not Required – IRR does not require the use of a “hurdle” rate (i.e., the cost of capital, or required rate of return at which investors agree to fund a project), mitigating the risk of determining a vastly divergent rate. IRR can be calculated independently of the use of such rates, and investors can then compare their own individual estimated cost of capital to the IRR as they choose.
Disadvantages of IRR
- Ignores Size of Project – Cash flows are simply compared to the amount of capital outlay generating those cash flows. This can be a disadvantage when two projects require a significantly different amount of capital outlay.
- Doesn’t Account for Unplanned Future Costs – Like most analytical tools, IRR only concerns itself with the projected cash flows and may not reflect unplanned future costs that may adversely affect profit. It is up to the investor to make sure that the pro forma projections adequately reflect, or reserve against, such “surprise” costs.
- Ignores Reinvestment Rates – Although IRR allows you to calculate the value of future cash flows, this calculation is based on the assumption that those cash flows can be reinvested at the same rate as the IRR. This may be an unrealistic assumption if the IRR is high, as opportunities to reinvest at such return rates may not in fact be available.
What is a cap rate and how can it be misleading sometimes?
A cap rate is calculated by dividing the annual net operating income (NOI) by the price of the property. Put simply, the cap rate represents a property’s expected yield in a one-year timeframe, based on the income it generates. However, it can be misleading if not used properly:
- By its nature, commercial real estate is highly illiquid and therefore sufficient sales data is not always available to determine the appropriate “market” cap rate to apply to a property. Even when comparable sales data is available, it’s very difficult to find two properties that are truly apples to apples.
- NOI does not take into account the cost of financing and therefore the cap rate of a property may not accurately reflect the true risk-adjusted return potential of an asset that will ultimately be financed using some form of leverage (debt).
- Cap rates can be viewed as a reflection of the premium demanded by the market to compensate for the perceived risk in any real estate investment. Given this information, when relying on cap rates as a way to make decisions, it’s important to keep in mind whether or not the cap rate is based on forward-looking projections.
Projections are what we call “pie in the sky” unless the assumptions are realistic!
All too often, you see people trying to raise money or sell a property basing their values on future cap rate projections which in turn rely on extremely optimistic views of future events.
While cap rates can be a very useful back-of the envelope way to quickly assess and compare the value of different real estate properties, it’s important to remember that cap rates may be limited in how much they can tell you about the overall quality of any property or real estate investment. As an investor, it’s important to recognize the difference between what the actual cap rate is of a property today versus what someone may be trying to convince you it will be in the future. Like all forward looking projections when it comes to real estate investments, the output is only as sound as the assumptions that are input into the formula.
R2 investing: Informed & Educated