There are two main ways real estate investors determine their return on investment (ROI): Cash-on-cash return and internal rate of return (also known as yield).
Knowing both of these terms and how to calculate them is an important part of being a successful real estate investor. But it’s equally important to know which gives a more accurate picture of your return and when to use both calculations.
Let’s dive into each of these methods of calculating an ROI to determine the differences and when to use each.
Cash-on-Cash (CoC) return
This is a simple calculation that takes the total pre-tax net profit in a given period (usually a year) divided by the initial investment. It's typically shown as a percentage.
Let’s use a real example to show how to determine CoC return on a single-family rental.
You found a potential investment. You’re able to buy this rent-ready house for $170,000. You get a bank loan and put $34,000 down and you secure a tenant at $1,500 per month. After holding costs and your mortgage payment, your pre-tax net income is $319 per month. So, in a 12-month period, you would receive $3,828.
To determine your cash-on-cash return (CoC), take your annual net pre-tax income and divide that by your initial investment.
That gives us a CoC return of 11%.
Internal rate of return (IRR) or yield
Internal rate of return, or yield, is forward-looking: It takes into account the role of money and time, considering things like current value and future value. It's used in all types of investing and may be called return on invested capital or net present value (NPV).
An IRR still calculates a return over a set period of time (typically 12 months) and is shown as a percentage. The biggest difference with IRR or yield is that it allows you to adjust payments if there are fluctuations in income or uneven cash flows.
This calculation is more complex and is typically done with a financial calculator or in a spreadsheet. But it can be done by hand with a standard formula.
CoC vs. IRR -- which is better to use?
Here’s a personal example of when the IRR or yield was a more realistic representation of my return.
I’m currently buying a storage facility that will have uneven cash flows over the four-year period I plan to hold it. Since I want to see what my ROI will be over the four-year period as a whole, I used an internal rate of return to help me calculate my overall yield.
In the spreadsheet below, you can see my estimated net monthly cash flow, which is the pre-tax income that I collect after paying any debt service like a bank and expenses. While the CoC return on investment at 325% is correct, the yield gives me a more accurate representation of the overall return of 38.38% over the period of four years.
Both are important and play a role in calculating whether an investment is worth your time and money. But if you have uneven cash flows, a depreciating asset, or want to see your return based on the real-time held period, IRR or yield is typically more accurate.
Cash-on-cash return will always be the easiest to calculate. And it reigns supreme for cash-flowing assets with consistent income over time. It's good for calculating a return on:
- residential rentals,
- stable income-producing commercial assets like apartment complexes, and
- fix and flips.
When you evaluate an investment, you're ultimately determining if it provides a high enough return to be worth spending money and time on. Understanding how cash-on-cash return and IRR or yield compare helps you analyze and compare real estate investments. In the end, they'll help determine which has the best ROI for you.
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