Cash on Cash Return & Internal Rate of Return: What Are They and Why Are They Important?
When analyzing a real estate investment opportunity, investors are interested in understanding the returns of the investment opportunity to understand how well their money will perform, how long it will take for their money to realize this return, and how this investment opportunity stacks up against alternative investment strategies.
Two popular metrics for understanding the returns of a real estate investment are Cash on Cash (CoC) Return and the Internal Rate of Return (IRR). Both metrics provide important insight to the investor to ensure this meets the investor's investment criteria. However, these metrics provide investors with two different perspectives on their investment which are important to understand. This article intends to cover both CoC and IRR: what are they, why are they important, which one should you focus on?
Cash on Cash (CoC) Return:
Cash on Cash Return is arguably the simplest method of evaluating the performance of a real estate investment. CoC return is focused on the return of an investment in a given year, and is calculated by taking the property's net cash flow (cash earned) and dividing it by the initial cash invested (equity). For example, if an investor purchases an investment for $100,000, and in year 2 of that investment the net cash flow is $10,000, this would reflect a 10% CoC return ($10,000/$100,000). Note that the net cash flow in a given year of an investment can change, which in turn will change the CoC return. If in year 3 the investment net cash flow is $12,000, the CoC return would be 12%. As cash flows can vary year on year, CoC returns for an investment are typically provided as an average over the investment lifecycle.
Internal Rate of Return (IRR):
Internal Rate of Return is one of the most popular investment metrics as it factors in the total return earned throughout the investment lifecycle. The IRR takes into account the time value of money, meaning that it factors in the time it takes an investor to receive their initial investment and profit back. The IRR formula is complex, but thanks to Excel we are able to easily compute IRR by taking the projected (or actual) return on investment each year during the investment lifecycle and utilize Excel's function to provide us IRR as a percentage. The most simplistic way to explain IRR is that it is the percentage rate earned on each dollar invested for each period of time that its invested.
Which Metric Should I Focus On?
The short answer is both. It is important for investors to utilize multiple metrics to analyze the potential of a real estate investment and ensure that it meets their investment criteria. CoC return will be helpful in understanding the average cash flow an investor can expect to receive each year of an investment, which may be important for someone looking to leverage this cash flow for monthly expenses. IRR is useful to the investor in understanding how their money will perform over a period of time and utilizing the IRR as a comparative metric for other investment criteria. Note that there is a premium on the time it takes for money to be received from an investment (time value of money). For investments of longer duration, or investments that have more associated risk, there is generally a higher targeted IRR for these investments to offset the time value of money. Assuming the underwriting and investment strategies are sound, these longer duration (or high IRR) investment opportunities can provide significant returns compared to investment alternatives.
It is important for each investor to plan out their investment criteria and goals. The investment metrics covered in this article are tools to help evaluate real estate investment opportunities prior to investing money and help make more savvy investment decisions.