Cash on Cash vs IRR: Which Is Best For You?
There are a lot of metrics you’ll hear in commercial real estate investing, especially when you start looking at different syndications and passive investments. Cash on cash vs IRR are the two to pay the closest attention to.
If you’re investing because you want passive income right now, cash on cash is the more important metric. If you’re investing to build wealth over time, IRR is a better metric.
I’ll cover both, along with the other metrics I mentioned. Knowing the details of the formula and what to look for can help compare different real estate investment projects.
What is cash-on-cash return?
Cash-on-cash return measures how much income the property generates compared to the cash you invested in the deal. It looks only at the annual net cash flow and ignores appreciation or profits at sale. It answers a simple question of how much cash flow this property paid you this year, based on your actual cash invested.
Personally, I pay close attention to this metric. At this stage of life, I’m focused on opportunities that generate passive income. Along with investing in our own deals, I invest in other syndications to diversify my portfolio, and I’m usually looking for at least a 10% cash-on-cash return.
To calculate your cash-on-cash return, you’ll take the total cash invested divided by the annual cash flow, which equals the cash yield.
Here’s an example:
- Initial investment: $100,000
- Annual cash flow: $10,000
- Annual cash on cash return: $100,000/ $10,000 = 10%
Cash flow and debt service
So what happens on the back end for a syndicator to be able to provide distributions and a return to you? Basically, whatever is left after the property pays for expenses and debt service payments is cash flow.
When you’re looking at investment properties, here’s how I’d evaluate to see if the projections from the syndicator are realistic or not:
- Net operating income: What are the sources of income, and is it enough to cover expenses? What are the opportunities to increase income, which would then increase net cash flow? In hotels, we look at things like winning large travel contracts or increasing revenue through areas like food and beverage.
- Expenses: It’s a good idea to look at the operating expenses for the specific project and property type and see if they’re realistic. For example, in hotels, there’s a certain level of payroll that we expect, and if it’s low, we question how the property can operate at that level.
- DSCR: This number represents the debt service coverage ratio and tells you if the property makes enough money to generate cash flow. It’s calculated by dividing cash flow after expenses by debt service payments. A DSCR of 1 means the property can cover its debt, and a DSCR of 1.2 means it makes 20% more money than needed to cover the real estate loan.
After you’ve looked at these areas as part of your investment due diligence, you’ll get a sense of whether there’s going to be enough cash flow and what kind of return metrics are realistic.
Financing options and impact on your returns
Financing and debt service flexibility greatly impact your cash-on-cash return. For example, one of the big benefits to our Barcelona Hotel fund project is that we’ve found financing options to be more flexible in Spain than in the United States. For example:
- Interest rates: Current commercial real estate loans are about 3-4% lower than what we currently see in the U.S. This increases the amount of cash yield and investor distributions we can generate.
- Seller financing: We see a lot of small family-owned properties, and sellers are more willing to offer seller financing, which can keep our debt service low.
If you compare properties between the U.S. and Spain, you’ll find that similar boutique hotels would sell for 5-10x the price here in the United States. Yet, we can command the same type of nightly hotel rates you’d see here. All of this means better cash flow and better returns, which is why Spanish real estate investment properties are hot right now.
What is internal rate of return (IRR)
Internal rate of return is a whole different metric and isn’t necessarily about annual cash flow at all. IRR measures the annualized return of an investment over the entire hold period. It accounts for the time value of money, not just how much you receive. It’s the interest rate that makes the net present value of all of the property’s cash flow zero.
You can use internal rate of return to compare deals with different timelines. And you’ll see a higher IRR when you get cash earlier than later.
The calculation itself requires specialized tools, but accounts for:
- Initial investment: Your initial cash outflow into the syndication or real estate project.
- Cash inflows: Cash flow distributions that you receive during the hold period.
- Final sale: Cash inflows from selling the property or exiting the investment.
- Timing: When the inflow or outflow occurs.
Other metrics in passive real estate investment
Some of the other metrics you can use to evaluate investment properties include:
Equity multiple
This measures how much you get back compared to your equity invested in the project. If you invest $100,000 and the total return over the hold period is $300,000, the equity multiple is 3.0.
The drawback to using equity multiple to evaluate alternative investments like real estate is that it doesn’t factor in time. It only looks at total dollars in and total dollars out.
Return on investment
Most people are familiar with this metric, which shows the total gain or loss compared to the original amount you invested. Here’s an example of how it works in real estate investing:
- Initial investment: $100,000
- Annual cash flow for 3 years: $5,000
- Proceeds at sale: $10,000
The calculation is:
- Total cash return: $25,000
- ROI calculation: $25,000/$100,000 = 25%
Net operating income (NOI)
NOI shows how much income the property produces after paying its operating expenses. It’s the number that reflects how the property performs on its own before the loan payment. To calculate it, take the total income the property brings in and subtract the operating expenses.
Here’s an example:
- Rental income: $50,000
- Maintenance expenses: $5,000
- Payroll: $10,000
- Property taxes: $5,000
The calculation is:
- Income less expenses: $50,000 – $20,000 = $30,000
Cap rate
Cap rate measures the property’s net operating income compared to the purchase price. Say the example property type above costs $500,000, here’s how to calculate the cap rate:
- Net operating income: $30,000
- Property market value: $500,000
The calculation is:
- NOI/market price: $30,000/$500,000 = 6% capitalization rate
Cap rates tell you about the property risk. A higher cap rate means a higher risk property, which you might see with run-down properties that need a lot of maintenance, tenant clean up, or raising rents to meet market conditions.
Meanwhile, a brand-new Class A apartment complex that’s very stable will have a lower capitalization rate because there’s way less risk.
Cash on cash return vs IRR: which makes more money?
I’m going to be like an IT person and say “it depends”. That’s why you have to look at every deal based on your individual needs and what you’re looking for. Here’s a quick little matrix that you can use:
| Detail | Cash on cash return | Internal rate of return |
| Measurement | How much income can this real estate investment give me this year? | What is my annualized rate of return at the end of the project? |
| Formula | Annual net cash flow/cash invested | Complex formula (using Excel or special tools) calculating the rate |
| Time horizon | Snapshot of one year | Entire investment hold period |
| Pros | Gives you a quick idea on passive income for your investment | Tells you the overall return metrics for the whole time you’re invested |
| Cons | Doesn’t factor in property appreciation and how much you can make at sale | Can be misleading if the project is very short and assumes you can reinvest cash profits at a high rate (which might be hard to find) |
First-year challenges in real estate investing
The reality of investing in any property, whether you’re actively investing or you’re investing in a property syndication, is that it takes some time to stabilize the property. So you don’t always get a lot of cash flow in year one. Properties that you invest in for more than a year can see results from those initial stabilization efforts.
For example, these are the kinds of things a syndicator tackles in year one:
- Rental income: Evicting bad tenants and finding ideal tenants who pay rent on time and stay for as long as possible.
- Deferred maintenance: Taking care of any maintenance that the previous owner neglected.
- Marketing: In hotels, we might rebrand the property or increase marketing.
Final thoughts for all real estate investors
The bottom line is that looking at these various metrics can help you understand an investment’s performance and whether it’s the right opportunity for you.
Investors often use both cash-on-cash return and IRR to evaluate the potential of real estate investments. To make the best decisions, you’ll want to compare apples to apples as much as possible. These calculations give you a way to do that.
Our Barcelona Hotel fund offers a mix of both with projected cash flows and an IRR of 21.73% and an equity multiple of 3.05. Click here for the offering flyers and details to learn more.
Cash on cash return vs IRR: FAQs
What is the difference between cash on cash VS IRR?
The biggest difference between the two is that cash on cash just looks at an annual number, and IRR looks at your total investment over time. Which is better? It depends on your goals if you want:
- Passive income: The cash-on-cash return indicates how much cash flow you can generate from the investment. Let’s say you want to make $50,000 in passive income, and the return is 10%. You’ll need to invest either $500,000 in one investment or divide the $500,000 into multiple syndications or projects to get to that income level.
- Grow wealth: If you want a 2x return on your investment within a specific timeperiod, this is when you’d look at internal rate of return (IRR). It tells you the total return, including cash flow plus proceeds from the sale, and assigns a higher “score” for reaching the return faster.
Is 7% cash-on-cash return good?
7% cash-on-cash return is OK. It’s a 7% return on your investment. It’s higher than you can get with a:
- High-yield savings account
- Money market account
But it’s lower than you can get with:
- Strong investment properties
- Solid stocks or index funds
Most syndication real estate investments target cash-on-cash returns closer to 8-12%.
When to use cash-on-cash return?
You should focus on cash-on-cash return if you’re trying to generate passive income. If your goal is something like $100,000 a year in passive income, you want to look closely at investments that produce steady cash flow.
To meet your goal:
- Capital: Know how much capital you can invest and look at the projected cash-on-cash return for each project.
- Research: Do your due diligence on the syndicators and property type/market opportunity.
- Invest: Invest in one project or spread your capital across a few passive investments to reach the income level you want.
This information is for informational purposes only and does not constitute tax, legal, or investment advice. Consult your own professional advisors before making any decisions. This is not an offer to sell or solicitation to purchase any securities. Investment opportunities with Gateway Private Equity Group are available only to accredited investors.
