You say “poh-tay-toe” … I say “poh-tah-toe”
You say “IRR” … I say “Cash-on-Cash”
So, what’s the real difference?
There are many financial metrics when it comes to the investment and financial world. Every shrewd investor knows that understanding the financial benefit and rewards of an investment is essential to evaluating and comparing investment opportunities. But do you have to have a PhD in Finance from the Mays School of Business at Texas A&M University (A/K/A the Harvard of the South) to understand the myriad of ways to calculate this benefit?
Well, a Doctorate in Finance may help if you are seeking to calculate the After-Tax Financial Management Rate of Return, or the Black–Scholes-Merton partial differential equation to calculate the price of an investment option. But what about a simple way to compare alternative real estate investments?
When it comes to commercial real estate investing, there are two metrics that are most used to evaluate potential returns: Cash-on-Cash Return (“CoC”) and Internal Rate of Return (“IRR”). In this article, I want to help explain the definition of each, and I certainly hope that this helps with your analysis and decision-making for real estate investing.
Calculating CoC returns is simple and is a rudimentary way to understand an investment return. In short, it is calculated by dividing the total net cash flow of a property on any given year by the total initial investment amount. The net cash flow of a property is essentially the free cashflow after paying for all the necessary expenses for the year, including operational expenses, property taxes, insurance, debt service, reserves, etc. (“Free Cash Flow”).
The total initial investment of a project can be calculated two separate ways, but considers not only the purchase price, but also the closing costs, renovation costs, and any other costs needed to close the transaction (the “Total Investment Amount”). As an alternative way to analyze one’s CoC Return and understanding that oftentimes an investor can borrow debt to make an investment, you can also simply look at the equity investment made, which is calculated by taking the Total Investment Amount, minus any debt (or leverage) that was borrowed, and results in your actual equity investment (the “Total Equity Investment”).
For example, let’s say we are buying an apartment building, and after the purchase price, closing costs and reserves for renovation, we have a Total Investment Amount of $5 million. If we can borrow $4 million from our local bank to complete the purchase and renovation, then we must invest a Total Equity Investment of $1,000,000 to cover the down payment and closing costs for the acquisition. Then, after our first year of owning and operating the apartment building, we end up with Free Cash Flow of $70,000, then this means that the CoC Return on Total Investment was 1.4% ($70,000 divided by $5 million), yet the CoC Return on the Total Equity Investment was 7% ($70,000 divided by $1 million). If your Free Cash Flow in year two and three grows to $85,000 and $100,000, respectively, then your CoC Return on the Total Equity Investment would be 8.5% in year two, 10.0% in year three, and so on.
Cash on Cash Return on Equity = Annual Free Cash Flow / Total Equity Investment
Cash on Cash Return on Total Investment = Annual Free Cash Flow / Total Investment Amount
I would suggest that Eduardo create some sort of nice graphic showing this formula
Internal Rate of Return
As an alternative investment return calculation, we have the IRR, which is a more sophisticated metric because it considers the time value of money. Essentially, the IRR considers either the Total Investment Amount or the Total Equity Investment, and the projected or actual Free Cash Flow, and determines the annual rate of growth of an investment according to when the future cashflows are received. Since the IRR considers the time value of money, then the quicker the positive cash flows are received, the greater the IRR.
For example, let’s consider two different projects … one based on the Free Cash Flow outlined above, and assume that you sold the investment at the end of year 3 and simply got your initial Total Equity Investment back. In the second example, assume that the Free Cash Flows were reversed, i.e., the only difference with the two is how fast you receive that return. As you can see in the table below, the project that provides a quicker return on investment will have a greater IRR:
As can be seen, the total CoC Returns for the three-year investment in each of the foregoing scenarios, are identical. However, the more sophisticated, IRR analysis, detects the slightest change in timing of Free Cash Flow, and takes that into consideration in the calculation.
When analyzing different investment opportunities, a simple side-by-side CoC Return analysis of your investment options can give you a simple rule of thumb return and indication of which investment to make. However, prior to making your final investment determination, the financial metric that most investors use while analyzing real estate investments, from the largest of institutional investors, to the smaller, yet sophisticated individual investors, is the IRR. No, you do not need a PhD in Finance from Texas A&M University, but the IRR calculation must be determined even if it is to gain a slight 16-basis point edge, as outlined above in scenario 2.