Cap rate, cash-on-cash, or IRR: which return metric should you use?

Cap rate: the price of the income

Net operating income divided by price. It ignores financing entirely, which is its strength: two buyers with different debt still see the same cap rate on the same building, so it works as a pricing comparison across deals and across markets.

Its weakness is that it is a single year and it ignores capital. A building that needs eight million dollars of deferred maintenance trades at a cap rate that says nothing about the eight million. Going-in, exit and stabilized cap rates are three different numbers, and a quoted cap rate without which one it is means very little.

Cash-on-cash: does it feed itself

Levered cash flow after debt service, divided by the equity invested, for a given year. This is the metric that tells an investor whether the deal distributes cash while they hold it, which matters enormously to some investors and not at all to others.

It says nothing about the sale and nothing about the years you are not looking at. An interest-only period flatters it for exactly as long as the interest-only period lasts.

IRR: the whole hold, time weighted

The discount rate at which the deal's cash flows net to zero. It is the closest thing to a complete answer, and it is also the easiest to manipulate, because it rewards speed. A shorter hold at the same multiple produces a higher internal rate of return, so a deal can be engineered to look better by assuming an earlier exit rather than a better outcome.

It is also dominated by the exit assumption. In a five year hold the sale is usually the majority of the value, which means the internal rate of return is substantially a statement about the exit cap rate. Change the exit cap by fifty basis points and watch what happens.

Levered and unlevered internal rates of return answer different questions again. The unlevered figure measures the real estate. The levered figure measures the real estate plus the financing decision.

Equity multiple keeps IRR honest

Total distributions divided by total equity. It has no opinion about time, which is precisely why it belongs next to a metric that is all about time. A 2.19x equity multiple over five years with no interim distributions is roughly a seventeen percent internal rate of return; the same 2.19x over eight years is closer to ten percent. Neither number is wrong and neither is sufficient.

Yield on cost and the development spread

For anything with a construction or renovation budget, the metric that matters is yield on cost: stabilized net operating income divided by total cost including land, hard costs, soft costs and carry. Compare it to the cap rate the finished asset would trade at. The gap between the two is the development spread, and it is the compensation for taking the execution risk.

If the spread is thin, no internal rate of return presentation makes the deal safe. It just makes it leveraged.

How to quote them without misleading anyone

The habit that prevents most of the damage is a labelling discipline. Never quote a cap rate without saying whether it is going-in, exit or stabilized. Never show a cash-on-cash without the year it belongs to, since year one and the year the interest-only burns off are different deals. Never show an internal rate of return without the equity multiple beside it and the exit cap that produced it, because that assumption is usually carrying the number. And anything with a construction or renovation budget gets a yield on cost quoted against the market cap rate for the finished asset.

Altyst reports levered and unlevered internal rate of return, equity multiple, cash-on-cash by year and on average, yield on cost, and development profit and margin, alongside base, upside and downside cases. The internal rate of return solver is decimal-exact and guards against the spurious roots a spreadsheet function can return on a sign-alternating cash flow.