Most of your are familiar with ROI (Return on Investment), but much less are familiar with IRR and CAP, two very common acronyms in the commercial investment world.
CAP – Capitalization Rate
This is the net income of a property divided by the price you’re paying for the property. For example, if a retail strip, 4-plex, or whatever are producing $100,000 net income (after all expenses are paid out) and you’re buying the property for $1M then the CAP is 10%. Certain types of property tend to trade at lower CAPs because they are in higher demand (or are less risky). If you were to buy a retail strip anchored by CVS, then you’re likely to pay around 4% CAP. So if we know that shopping center is bringing in $100,000 then we can divide by 4% to find what the market value of the property is: $4M. Quite a difference.
IRR – Internal Rate of Return
This is essentially ROI broken down into an annual return. If you are an investor in an apartment flip, then you’re likely looking at 5 year turn-around. The project may have a 120% ROI but this is a 5 year project so the average annual ROI or IRR is 24%, a respectable IRR for a passive investor. When looking at projects, IRR is the most important because it takes time into account.