Cash-on-Cash vs. IRR

[Kyle Ropelato]

I'm new to BP and REI in general. I've been an agent for over a year in Utah and now looking to get some rental properties. I am reading a lot of books and watching a lot of webinars. A lot of investors talk about the cash-on-cash return that a property offers, but I just finished Frank Gallinelli's book, "What every real estate investor needs to know about cash flow...and 36 other financial measures" and in it he talks about how cash-on-cash can be very deceiving and a better metric to use is IRR.

Do any investors go to the length of trying to calculate IRR when they are analyzing properties? Or do you guys use cash-on-cash as a quick and dirty metric to know if you're interested in the deal or not? Has anyone been deceived by an initial cash-on-cash return?

If IRR is used, have you found a good tool to calculate it that integrates well with the BP calculators, seeing as how they only give you cash-on-cash?

[Tom Shallcross]

Because I plan on holding my properties for a long period of time I do calculate IRR as CoC does not take into account the time value of money. After year one, IRR will be much more accurate and it's also the most straight-forward route to compare different investments - real estate or other - based on yield.

One last formula to throw in is your return on equity. A much wiser/more experienced investor explained this one to me and it's caused me to slightly adjust my strategy. On year one it will be similar as CoC but as your tenant pays down your mortgage, your equity increases (which is a good thing) but your Return on Equity will decrease. Fast forward 5 years and although rents should go up a few hundred bucks, these rents won't go up as quickly as you are paying down the mortgage. This equity is now gaining a lower return and it may be time to look at alternative options. Quick summary, return on equity is a great metric to evaluate if the equity in the property is being used to it's maximum potential or if it's better move it elsewhere such as leveling-up to a larger property or different asset (note you don't have to sell, you can refi, take a HELOC....etc).