What Is the Difference Between Cash on Cash Returns and an Internal Rate of Return?
Both cash on cash returns (CoC) and the internal rate of return (IRR) are fundamental concepts for real estate investors. Both are metrics that can prove very useful when you want to evaluate how well your investment is performing, or when you want to compare the profitability of future investments.
So, both are useful, and both are widely used for similar things, but what is the variance between the two? If you are an investor and you believe that you know the difference between CoC and IRR, it would still do you good to read this short text as many investors often make mistakes with the two and when they are supposed to use them.
Cash on Cash Returns (CoC) Explained
CoC determines your return on the invested capital, and it’s the relationship between the original equity investment and the cash flow of the property. The cash flow in cases where CoC is used is the profit you make after you pay all the operating expenses as well as the debt service.
On the one hand, CoC is more useful than your standard ROI metric as it’s a more accurate representation of your investment’s performance, as well as a helpful comparison metric for different investment opportunities. On the other hand, it’s not useful in the long run (even one year after your investment) as it doesn’t take in the appreciation of the property nor the time value of money.
It’s up to you to determine how useful the metric is to you and it’s up to us to explain how it’s calculated. The formula is:
Net operating income (NOI) / Cash Invested = Cash on cash return
The formula is easy to use, but which results are good? Most real estate experts disagree on this, but the consensus can be viewed as somewhere between 8% and 12%. However, some other experts believe that CoC shouldn’t be below 20%.
Internal Rate of Return (IRR) Explained
The IRR determines the rate at which your real estate investment grows or shrinks. Essentially, IRR is the percentage rate you earn on each dollar you’ve invested during the entire time you’ve been holding the property.
More importantly, IRR comes in handy as CoC, as we’ve previously mentioned, doesn’t account for the change in the time value of money. Additionally, it can go together with CoC as it can be calculated using the same data you’re applying to the CoC metric.
However, none of this means that the formula for this metric is simple. On the contrary, it’s complicated and can hardly be done by hand. If you want to calculate IRR, it’s best to either use the IRR command in Excel or to use any real estate investment tool.
In the end, you most likely still want to know which IRR result is favorable. Unfortunately, we can’t tell you that as these results are often misleading and you thus shouldn’t look for a superb result. All competent real estate investors use IRR together with other metrics like the already discussed CoC metric to get something that they can use with certainty.
So, all in all, it’s best for you to use both metrics when you need to calculate how profitable your investment is. For more information, you may reach us at info@cbicommercial.com
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