As discussed in previous articles, the capitalization rate or cap rate is a measure, expressed as a percent, of what investors are willing to pay for a dollar of net operating income (NOI). Cap rates are used to calculate property values by dividing the NOI by the market cap rate for similar properties (Value = NOI / cap rate). The simplicity of direct capitalization that make it a popular and commonly used valuation method also contribute to its shortcomings.
Because the use of cap rates only considers the first year of projected NOI the method does not account for changes in net operating income over the holding period nor does it consider the effects of leverage/financing or the tax benefits associated with real estate ownership. These additional considerations impact the internal rate of return (IRR); making it a much more comprehensive and useful method of evaluating investment performance.
IRR is the rate of return that each dollar in an investment earns while it is in that investment. Other terms that are synonymous with IRR include: interest rate, discount rate, and yield. IRR uses the cash flow model approach to isolate the return on the total amount of money received over an investment’s lifecycle. As a result, IRR gives investors the ability to compare alternative investments over their projected holding period based on their respective returns/yields.
A common misconception is that some investors assume that the cap rate will be equal to the IRR; however, this is rarely the case. Without taking into account the effects of financing and taxation, which also contribute to differences between cap rate and IRR, the relationship between the two can be described as such:
Cap rate + Growth = Internal Rate of Return