In commercial real estate investing, using a variety of performance metrics is crucial for gaining insights and making informed comparisons between potential investments. Two commonly used metrics—cash on cash return (CoC) and internal rate of return (IRR)—help investors evaluate and compare properties effectively when deciding where to allocate capital.
Typically, investors establish their own benchmarks for acceptable returns to meet specific financial goals. With multiple opportunities to assess each day, having clear, straightforward metrics is essential. Both IRR and CoC are foundational tools, and understanding how they differ is critical for sound investment decisions.
Understanding Cash on Cash Return (CoC)
Cash on cash return is a rate of return measurement that reflects the total cash income generated relative to the total cash invested. It is calculated based on the cash flow before taxes during a specific period, divided by the equity invested at the end of that period.
Because CoC is a levered metric, it accounts for financing and debt, unlike unlevered returns, which assume no debt. Investors often use CoC to evaluate the profitability of a real estate investment.
Formula for Cash on Cash Return The basic formula is:
Annual Net Cash Flow ÷ Total Invested Equity = Cash on Cash Return
Typically expressed as a percentage, this calculation shows the return generated on the actual cash invested.
Example Calculation of Cash on Cash Return
Suppose Bob plans to buy a multi-tenant building for $1 million, contributing $250,000 in equity and financing the remaining $750,000. (Note: Closing costs, if paid out of pocket, would also add to equity.)
After one year, the property brings in $120,000 in rental income. Bob’s mortgage payments total $55,000, and he invests an additional $20,000 in property improvements.
To calculate annual net cash flow:
Total Revenue – Total Expenses = Net Cash Flow
In this case, $120,000 – $75,000 = $45,000.
Then, to find the cash on cash return:
$45,000 ÷ $250,000 = 18%
This means Bob’s investment yields an 18% return on his initial cash investment annually.
What Constitutes a Good Cash on Cash Return?
This varies widely based on investor expectations and goals. Some are satisfied with returns in the 8–10% range, while others look for opportunities offering 20% or more.
Limitations of Cash on Cash Return
While CoC is a helpful quick assessment tool, it doesn’t account for investment duration, future cash flows from property sales, or reinvestment risk. It should be used alongside other metrics for a full investment analysis.
Explaining Internal Rate of Return (IRR)
IRR measures the annualized rate of growth an investment is expected to generate, accounting for the time value of money—something CoC does not consider.
Technically, IRR is the discount rate that brings the net present value (NPV) of all cash flows (both income and sale proceeds) to zero.
Internal Rate of Return Formula
IRR calculations are typically complex and best performed using Excel or financial software. The formula is:
Where:
- Ct = Net cash inflow during the period
- C0 = Initial investment
- IRR = Internal Rate of Return
- t = Number of time periods
What is a Good IRR?
Acceptable IRR targets vary, but many investors look for a 5-year IRR of 15% or higher, depending on risk tolerance and market conditions.
Limitations of IRR
While IRR is a powerful measure, it has drawbacks. A high IRR does not always indicate strong near-term cash flow, as it factors in eventual sale proceeds. As such, IRR should not be used in isolation when evaluating investments.
Key Differences Between Cash on Cash Return and IRR
While CoC measures the annual cash income relative to the cash invested, IRR captures the overall rate of return over the life of the investment, including both ongoing cash flow and final sale value. CoC offers a snapshot for a single year, whereas IRR provides a comprehensive long-term perspective.
When to Use Cash on Cash Return vs. IRR
Although IRR provides deeper insights, it requires detailed projections and complex calculations. Many investors use CoC early in their screening process and reserve IRR analysis for final decision-making on promising deals.
Conclusion
Choosing between CoC and IRR isn’t an either-or decision—savvy investors use both. Cash on cash return offers a quick look at annual performance, while IRR provides a fuller picture of total investment profitability over time. Using both metrics together helps investors make well-rounded, confident decisions tailored to their specific financial goals.