Which indicator is better? Cash-on-Cash or IRR?

Question

The formula for cash-on-cash is cash flow divided by total cash invested (aka down payment). To my knowledge, it's primarily a single-annual indicator meaning the cash flow is annualized and only for one year, whereas IRR takes values over several years (5-10 on average in my experience).

I use CoC all the time, rarely ever use IRR because it can be hard to predict income multiple years out but I recently met someone who is religious about NPV & IRR. He just got a finance degree and supposedly those are the most important, but I just haven't found better use of them. So I wanted to get a second opinion. What's your standard of practice? Do you think IRR is more important than Cash-on-Cash? Obviously this is a per-deal basis but it's an interesting question.

Llewelyn A. · Answer

Account Closed

Thanks Mary for the Mention.

Joe, Caleb, I REALLY want you to look at this Spreadsheet so you can understand that IRR is REALITY AND it is ENTIRELY PREDICTABLE in VERY CERTAIN ways.

Here is the example:

Let's say you are going to buy a multi-family property with the following assumptions:

1) ZERO Appreciation

2) ZERO Cash Flow

3) Purchase Price: $1 Million

4) 20% Down, 15 Year Mortgage

On a CoCR Basis, this property SUCKS and the CoCR Investor will stay COMPLETELY Away from it.

BUT.. when you model it with an IRR, it looks like this:

NOTE: Both the Closing Costs on the Purchase AND the Sale has been accounted for.

CLEARLY, this property will be doing well as you are using a 15 year Mortgage and still breaking even in Cash flow throughout the 15 year holding period.

This is REAL... why?! Because an AMORTIZED FIXED RATE MORTGAGE goes away in 15 years. It is JUST MATH.

The CoCR does NOT take into account any of these future events, NO MATTER HOW CERTAIN THE OUTCOME will be.

In this case, the ending of the Mortgage is CERTAIN and is the only variable worth taking into account in this model.

There is NO Appreciation, NO Cash Flow, JUST the Mortgage.

This Property STILL returns 10% IRR which is a 10% Annualized Compounded Return on your Investment.

Those who do only a CoCR miss these things and cannot take into account ALL future Cash Flows.

BUT HEY.... Caleb's friend is absolutely correct. THESE Future Value calculations are the MOST IMPORTANT numbers PROFESSIONALS who have studied Finance, Investments, Stock Markets, etc. uses.

If the Pros use them, I would suggest we all use them as well.

Why would you do otherwise?

The fact is that the multitude of Investors don't study enough finance calculations to understand IRR or any of the Future Value formulas. That's all great for me! It eliminates the competition!

Immanuel Sibero · Answer

The way I see it... sources of return on investment in rental real estate:

1- Cash flow

2- Loan paydown and

3- Appreciation in value.

- CoC is a measure of return generated by TWO sources (i.e. Cash flow and Loan paydown) on an annual basis

- IRR is a measure of return generated by ALL THREE sources (i.e. Cashflow, Loan paydown, and Appreciation) throughout the life of the investment

Which is better? IRR, no contest... but my worksheets always have both because they are both useful in different ways. However, if you're strictly a cash flow investor and don't care about appreciation or you know there is zero appreciation then calculating IRR is like bringing a gun to a knife fight.

Cheers... Immanuel

Llewelyn A. · Answer

@Joe Villeneuve

You are mistaken to suggest that I have said that the $945k is a "Profit." It's not... it's a SALES PROCEED and that is EXACTLY as it is in the spreadsheet.

The IRR takes in those inputs and gives you an output.

The Expenses of $1,880, which is $1,880 x 12 months = $22,560 of Annual expenses which is why the cash flow breaks even. I made this to be the amount of expenses for the building including all the normal expenses.

BTW, I make $MILLIONs with these calculations.... ALL REAL.

Personally, it doesn't matter what you and I think. I can demo IRR until my fingers drop and there will still be people making their counter arguments, whether or not it is true or relevant.

Part of that is that the reader's understanding and interpretation of these spreadsheets and the IRR calculation is not fully understood.

BUT again.... that's perfectly fine with me! I put out the calculations, I also have an incredible history of success and the amount of REAL profits are measured by more than $10 Million.

I would say 90% of those who are biased against these future calculations will just continue with their bias. Works for ME! I'm just trying to help with this understanding of IRR, a calculations that again, as the OP suggested, is taught in Finance classes and used by the Pros.

BUT.... if you don't want to use it, you don't have to!

I can bring a Horse to Water but I can't force him to drink! :)

Ray Johnson · Answer

@Llewelyn A. Great post! Account Closed mentioned about property types, Those $30,000 Duplexes in Cleveland won't need an IRR template but the property in Brooklyn, NY or South Orange County, CA will.

Llewelyn A. · Answer

Account Closed

I want to also point out something that really bothers me about Cash on Cash Return.

Again, let's take an example:

1) Purchase Price: $1 Million

2) Investment: $230k

3) Cash Flow per Year: $23k

4) Cash on Cash Return: 10% (23k / 230k)

What bothers me about the Cash on Cash Return is that the Investor that uses this calculation doesn't really understand that HE ASSUMES THIS CoCR Ratio to be the SAME FOR THE ENTIRE HOLDING PERIOD.

BUT, if he did an IRR given the SAME FACTS, he gets this IRR Spreadsheet:

NOTE: The Mortgage is an Interest Only $800k at 6.3%. There is also a small amount of added FMV to account for the fact that CoCR DO NOT TAKE INTO ACCOUNT Closing Costs on the SELL SIDE.

The above Spreadsheet is the IRR Equivalent of a CoCR. It tells you a LOT. It tells you that you assumed that the next 15 years of your holding period, that your CASH FLOW NEVER CHANGES.

IF someone gave me this IRR Spreadsheet, I would just walk away from them because it's total B.S. There is NO SUCH THING as an Investment (other than a Zero Coupon Bond) that pays out EXACTLY the SAME Cash Flow EVERY SINGLE YEAR. Not only that, it DOES NOT TAKE INTO ACCOUNT THE Closing Costs when you SELL the Investment. Don't you think something is wrong with that at the very least?

I think when you really understand IRR and do it for every investment, you begin to understand what it actually means and then you gain a VISION of the future of your Investment, which is what every Investor needs to do.

If a Student gave me this IRR Spreadsheet, I would then tell him to at LEAST build the spreadsheet to ASSUME a 2.5% Increase in Rent Annually AND a 5% Increase of Expenses Annually.

Now the same IRR Spreadsheet looks like this:

The Purple Columns are new and your Cash Flows need to change.

Do you see how easy this stuff really is and how you can take into account REAL WORLD examples of what is going on?

Funny how the Virtual Reality is the CoCR calculation and the REALITY Calculation is actually the IRR!

I would say that if you are buying a $50k property... ok... I'll give it to you that it's such a small investment that MAYBE you shouldn't use the IRR because it "SEEMs" too much for so little.

BUT PLEASE.... by the time you get to a larger Investment, say $100k or more... ESPECIALLY in the Millions.... you MUST do an IRR and take EVERY Future Cash Flow into Account.

I know that some readers will just be biased against the IRR, they will still be the horse that I bring to the Water but just refuse to drink.

I say that if you are serious about expanding your portfolio, becoming that multi-millionaire (or billionaire), then do it from the very smallest to the largest investment as you grow.

Caleb, if you are having difficulty with my posts and these spreadsheets above, you are welcome to go to your friend who understands the importance of the IRR. Ask him to read through my posts and then explain it. If he needs my help, just send me a private message and I can help out.

I hope the Readers of this Post who has made a New Years Resolution to increase their knowledge of Investing, Real Estate or otherwise, take notice that this will be an exceptional tool for you once you understand it.

Bill F. · Answer

Account Closed excellent posts.

Asking if IRR or CoC is better is like asking if a tape measure or ruler is better. There is no right answer, they both have their strengths and weaknesses. It is up to the user to know and understand the limitations of each so they can apply them effectively.

Most glaring shortcoming of CoC : its a snapshot in time that cannot take into account the time value of money and only measures one of the was you make money in RE (Free Cash Flow)

A deficiency of IIR and really all DCF calculations: To use them you need to model out the four wealth generators (CF, Appreciation , Amortization, Tax savings). A smart guy once said "All models are wrong, but some are useful" It takes a lot of experience and discipline to know if your model is useful or if you are simply fooling yourself.

The best answer to your question: get educated about each so you can both instead of having to rely on others, some of whom don't understand the calculation, but nevertheless are more than willing to share their opinions.

Steve Vaughan · Answer

Early on for me it all about COC.  I needed cf and was the main metric I invested for. I acquired 35 or so C and B(-) class multifamily apts amd some houses. B and higher assets didn't cf enough so weren't on my radar.

12 or so years later, I won't pass up a good cf deal, but can 'rationalize' purchasing higher quality assets with shorter mortgage terms for the equity capture and eventual high IRR.  It's more about the later than the now. I have that option because the bulk of my little cashflow units are still producing.

I would have missed out on a ton of equity if all I did was chase COC.  2 houses I sold last year wouldn't have been.  A cash purchase I rolled profits into wouldn't have either.  These were break-even monthly but the built-in equity from buying right and the monster loan paydown monthly  were part of my calculations because IRR matters.

$200 or $400 per month cash-flow per unit is fine, but the real wealth is built buying odd or otherwise strong but unfinancable assets at discounts and repurposing or renovating smartly into something special.

Will I now buy an A class single fam at a 20% discount that only breaks even or loses a couple hun a month with 10% down? You bet. Strong equity that grows while it pays down several hundred per month. Massive IRR. We all have an IRR after we sell. Make it a good one.

Mary M. · Answer

Account Closed  there are several threads here that hash this out in detail. Try searching on “IRR” or IRR cash flow” in titles and see if you can find them.

I will take a look later when I have time.

David Monroe · Answer

Cash on cash accounts for money out of the investment, monies distributed, IRR accounts for the monies left in the investment, not distributed, thus the term internal. This is why it's so confusing to everyone.

In my experience IRR investors are usually institutional with safer investment plays. They rarely invest in under occupied assets, though they do like value plays on stabilized assets.

Mary M. · Answer

Any analysis based on FUTURE monies is to a degree “guessing”. However, as long as you use the baseline assumptions accross all properties that you are analysing you will get good information on which is the better investment

Obviously reality will be different but this will allow you to hone your skills etc. ALL future business analysis is based off assumptions (including budgets, etc) The data it produces is valid. Just ask the folks that use IRR NPV etc to invest :)

@Llewelyn A.,  can you help?

Which indicator is better? Cash-on-Cash or IRR?

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