Capitalization Rate (Cap Rate)
The capitalization rate (just called "cap rate") is the most basic, and widely used, metric in the real estate industry. The definition of the cap rate is the ratio of net operating income (NOI) to the property's value.
Cap Rate = Annual Net Operating Income/Property Value
For example, if a property is listed for $1,000,000 and generates NOI of $100,000, then the cap rate would be $100,000/$1,000,000, or 10%. The cap rate represents the percentage return an investor would receive on an all cash purchase. The cap rate is inversely related to the price of the asset. The higher the price, the lower the cap rate.
Net operating income (NOI) is the annual income/(loss) generated by a property after taking into account all income from operations and deducting all expenses incurred from operations. NOI is calculated as follows:
When a cap rate is quoted on a property, it is based on the NOI. NOI does NOT include: capital expenditures, leasing commissions, tenant improvements, debt service (interest expense + principal payments), capital reserves, and depreciation. The equivalent of NOI in the business world is EBITDA (earnings before interest, tax, depreciation, and amortization).
Cash on Cash Return
The cash on cash return measures the cash return against the total cash (equity) invested. The formula is:
The equity multiple is a ratio that divides the total net profit over the hold period plus the total amount of equity invested by the total amount of equity invested. Unlike IRR, the equity multiple of an investment does not take into account when the return is made. The formula is:
Internal Rate of Return (IRR)
In simple terms, the IRR is the return generated on an investment, typically expressed as an annual rate. IRR uses the basic time-value of money principle: A dollar today is worth more than a dollar in the future. As a result, the IRR value takes into consideration the timing of cash flows. In other words, the sooner earnings from an investment are received, the higher the IRR. To illustrate, in the example below, Scenario 1 received $196 in earnings during years one through seven and achieved an IRR of 14.5%. Scenario 2 has the same IRR but received $258 in earnings, all of which was in year seven. IRR can be calculated by hand, but that is a very academic exercise. Instead, use the IRR function in Excel.
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