One of the frequently asked questions in real estate investment is, “How much income can I anticipate making?” So before investing their money in a deal, investors will want to fully comprehend the pace of growth of their wealth. To measure returns, however, there are several techniques. The two most common types of investment return indicators in commercial real estate are the internal rate of return (IRR) and cash on cash returns. Due to the benefits and drawbacks of each, we will contrast cash-on-cash and IRR in this article.
We’ll discuss the following subjects in further detail:
- The Importance of Return
- Money on Money
- IRR
- Conclusions Regarding Cash on Cash vs. IRR
The Importance of Return
Conceptually speaking, return refers to how much money you gained (or lost) on an investment during a specific time frame. Say, for example, that you spent $10 on a stock that you subsequently sold for $20. You “earned” $10 on this purchase, correct?
Hang on a minute!
What would happen if, while you held the stock, inflation erupted out of control? The value of your original $10 investment is greater than the value of your future $10 profits. If I get a $10 refund, does that include taxes? The hold time will determine whether you must pay long- or short-term capital gains taxes. What if, while holding that stock, you had found a different investment opportunity that would have allowed you to make $20 instead of $10? Such a situation can lead you to believe that you lost $10 as a result of the opportunity cost.
In summary, it turns out that figuring out a deal’s returns is trickier than it seems. There are various ways to figure out if an investment was profitable or not. Internal rate of return, or IRR, and cash on cash are the two indicators that investors commonly use when investing in real estate. We’ll provide a broad overview of both in the sections that follow.
Define Cash on Cash
The phrase “cash on cash” refers to a way of figuring out a deal’s earnings depending on how much extra cash it generates over and beyond the initial investment. It’s critical to remember that this tool only evaluates cash returns within a certain time period, not the whole hold tenure.
Example
Let’s imagine that you are given the chance to purchase a residential complex. You put out $100,000 and get a 10% share of the business. However, it makes sense that you would want to assess the deal’s predicted returns before making a decision.
The apartment complex is expected to provide $50,000 in cash payouts in the first year, according to projections made by the deal sponsor. You will get $5,000 of that if there is a 10% stake. Cash on cash is the entire investment divided by a year’s worth of cash. Because of this, your first year’s cash-on-cash return would be equivalent to 5% ($5,000 payout divided by $100,000 investment).
Advantages and Disadvantages
The cash-on-cash method’s main benefit is its simplicity. For a conceptual understanding of what this measure signifies, you do not need any prior knowledge of accounting or finance. For instance, it is obvious that the real estate choice creates more cash than the savings account if the savings deposit account pays 2 percent and the real estate investment offers 5 percent cash on cash.
However, this ease of use is directly related to the disadvantages of using cash on cash as a transaction analysis indicator. Cash on Cash does not inform investors about the entire returns of a deal because it only accounts for one year. In the first year, 5 percent cash on cash may look fantastic, but what kind of returns can you expect throughout the deal?
Unfortunately, entire cash flows are not taken into account by cash on cash (both distributions and the ultimate sale of the property). Additionally, it doesn’t take into account the time worth of money. Future money becomes less valuable as a result of inflation. Because of this, if you forecast third-year cash-on-cash returns of 6%, you are failing to take into account the reality that those dollars are worth less than your initial investment, which means the actual cash-on-cash return will be lower than 6%.
Define IRR
With cash on cash, IRR, a measurement used in investment research, fixes the aforementioned issues. To properly appreciate this product, however, investors must have a solid grasp of the concept of the value of money. Investment returns increase with time. How much did the value of this money grow over time, though? Investors must provide a response to that question. In other words, if you will receive $100,000 in the future, what is the equivalent amount in today’s money?
IRR offers solutions to these issues. The IRR idea gives investors the annualized growth rate in the scenario where the initial cash investment is equal to the total value of all future cash flows. With IRR, investors may take into consideration both the total cash flows of a contract and the time value of money. To put it another way, it converts all of a transaction’s cash flows into current dollars.
Example
Let’s stick with the flat as our example. However, we will now take into account all of the deal’s cash flows, not just the initial one. Let’s say your predicted annual salary is $5,000 for years 1 to 4. The building will then be sold in year five, and your share of the revenues will be $200,000:
| Year | Cash |
| 0 | -$100,000.00 |
| 1 | $5,000.00 |
| 2 | $5,000.00 |
| 3 | $5,000.00 |
| 4 | $5,000.00 |
| 5 | $200,000.00 |
What type of profits does this contract provide if we translate the future cash flows into the first year’s dollars? Even though the actual computations to solve for IRR are challenging, the Excel formula =irr() makes this task simple. By employing this strategy, the aforementioned trade generates an IRR of 18.2%. In other words, 18.2 percent is the interest rate at which the initial cash investment is equivalent to the present value of all future cash flows. Therefore, you would receive an annualized rate of return of 18.2 percent for the course of the transaction.
Benefits and Drawbacks
IRR’s intricacy is one of its main disadvantages. Not all investors will have a complete understanding of the time value of money since it can be a difficult topic to understand.
But this extra complexity leads to a far broader measure. IRR provides investors with a deal’s total returns rather than just a year’s worth of cash flow. Additionally, it automatically takes into account the fact that money is currently worth more than it will be in the future. As a result, even if an investor does not completely comprehend the formulas used to calculate IRR, most will see the value of evaluating a deal’s overall returns.
Conclusions Regarding Cash on Cash vs. IRR
Investors shouldn’t inquire about cash-on-cash against IRR after taking into account the aforementioned history. Instead, they ought to evaluate every possible agreement using both methods. Smart investors will want to have a thorough grasp of cash-on-cash returns and IRR since each indicator has a distinct function in the analysis of a project.
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