IRR v. Cap Rate

[Tal B.]

1. Hi all,
2. 
   I was wondering if someone can explain in clear and simple language how is a Cap Rate different from IRR.
3. I understand Cap Rate (NOI/Asset) and kinda understand IRR.
4. Correct me if I'm wrong: It is when the NPV becomes zero. i.e. above it NPV is negative. Thus the higher the IRR the better. It needs to be higher than my cost of capital. However, is it by definition always higher than the cap rate?
5. 
   Can they sometime be the same? Is it different in that IRR relates to multiple future cash flows while cap rate is a fixed rate in time?
   When would you analyze an asset with IRR and when with a Cap Rate? 
6. Perhaps @Frank Gallinelli would like to comment. My questions rose after reading his great book "What Every Real Estate Investor Needs to Know About Cash Flow..."
7. Thank you in advance!!
8. Tal

[Frank Gallinelli]

Hi Tal --

You are correct that the IRR is the discount rate that causes the NPV of all cash flows to equal zero.

Regarding the difference between cap rate and IRR: You are also correct that the cap rate looks at a property's performance at a given point in time. This is why a commercial appraiser might prefer to capitalize the current year's NOI in order to estimate value, because he or she is trying to give an estimate of value as of a specific date.

IRR, on the other hand looks at the income stream over time. It might relate to the purchase, NOI, and gross selling price (so-called unlevered IRR); or it might use the cash invested, the after-debt-service cash flow, and cash proceeds from sale (so-called levered IRR).

It is worth knowing the capitalized value of the NOI since that presumably is what the property is "worth" today, and it is the value on which a lender will probably base financing. However, from the investor's perspective, it is even more important, I believe, to keep in mind that you are not investing for a point in time but rather for a longer term. For that reason, you want to develop some sense of how the investment will perform over the entire period you wxpect to hold it.

You may be able to anticipate the ebb and flow of your future NOI or cash flow within some reasonable range and thus perform an IRR calculation over your expected holding period. (For example, you property may have commercial leases with pre-defined step increases; or you may expect loss of revenue at the end of a lease term while you re-fit a space and seek a new long-term tenant). I always recommend using best-case, worst-case and in-between set of assumptions to decide in you can accept an investment that performs somewhere within that range.

Shorter answer: Income capitalization and IRR are different, but both are important. One seeks to establish a market value at a point in time, the other to give a sense of the investment's performance over the entire holding period. Ultimately, as an investor, I think the IRR has to trump the capitalized NOI -- in other words, if the property seems unlikely to meet my rate-of-return goal at the presumed current market value, then I want to find the value at which it WILL meet my goal.

Frank