Over the years, my experience in working with investors from different walks of life, has always fascinated me when it comes to what is their ultimate go or no-go decision when looking at investment real estate.
Some clients only look at the cap rate. Their rationale is that most of the time you can predict the first year of revenue stream but after that, it is all assumptions. It is simple and easy to calculate and really allows a person to play simple what if analysis based upon vacancy and operating costs because you are using the Net Operating Income (NOI).
Then I have some clients that want to take the analysis just one small step further and look at the Cash-On-Cash return based upon their investment. Most of these clients are utilizing OPM or debt and want to know if they buy an asset based upon a certain down payment with a certain loan that their actual cash-on-cash return will be. If the cash-on-cash return is higher than the cap rate – they achieve positive leverage and they will more than likely purchase the property. If the cash-on-cash return is lower than the cap rate – negative leverage – they will more than likely pass or try to renegotiate.
Some of my clients today are using Internal Rates of Return (IRR). There are some pros/cons to IRR measurements. From Wikipedia.org: IRR assumes reinvestment of interim cash flows in projects with equal rates of return (the reinvestment can be the same project or a different project). Therefore, IRR overstates the annual equivalent rate of return for a project whose interim cash flows are reinvested at a rate lower than the calculated IRR. This presents a problem, especially for high IRR projects, since there is frequently not another project available in the interim that can earn the same rate of return as the first project. Not to further pick on our friend IRR, but if you have a negative cash flow and then a positive cash flow but then lose a tenant and have another negative cash flow, your IRR could be misleading. Also adding onto this, someone has to make some assumptions about the property’s future cash flows (beyond year 1) and what you could sell the property for down the road.
So, why do we go through this brain damage? Two words: Opportunity Costs. Everyone only has so much money to do so many things and everyone wants to make sure they are getting the best return that they can on the money they have to invest!
I would be curious to know, what are you using when talking to clients about returns of a property?