Guide
Cap rate, cash-on-cash return, and IRR
Three numbers are routinely quoted as though they were interchangeable. They are not: one describes the asset, one describes your cash position, and one describes timing. Choosing the wrong one is how a mediocre deal comes to look excellent.
Written by AreaAlpha, Property Pulse product team. Last reviewed .
In short
- What is the difference between cap rate, cash-on-cash return, and IRR?
- Cap rate is net operating income divided by value and ignores financing. Cash-on-cash return is annual before-tax cash flow divided by cash invested and reflects financing but ignores timing. Internal rate of return accounts for the timing of every cash flow and becomes unstable over very short holding periods.
The three metrics
- Capitalisation rate
- Net operating income divided by price or value. It ignores financing entirely, which is exactly why it is used to compare properties: two buyers with different mortgages should still agree on the cap rate.
- Cash-on-cash return
- Before-tax cash flow divided by cash invested, for one year. It includes financing and therefore describes your position, not the property. Leverage raises it while also raising risk.
- Internal rate of return
- The discount rate at which every dated cash flow — acquisition cash out, operating cash in, and eventual sale — nets to zero. It is the only one of the three that accounts for when money moves.
What each one quietly leaves out
Cap rate leaves out capital expenditure and financing. A property with a failing roof and a healthy one can show the same cap rate in the year before the roof is replaced.
Cash-on-cash leaves out appreciation, principal paydown, and everything beyond the year being measured. It answers 'what did my cash yield this year', which is a real question, but a narrow one.
IRR leaves out scale: a large return on a small sum can beat a modest return on a large one and still be the worse use of capital. It is also acutely sensitive to the assumed exit value and date, which is where most optimistic models hide.
Short holding periods break IRR
An IRR computed over a few weeks annualises whatever happened in those weeks, producing figures that look dramatic and mean nothing. Property Pulse flags very short holding periods instead of reporting the annualised number.
Choosing the right figure
Match the metric to the question actually being asked.
- 01Comparing two properties on the market, ignoring how each would be financed: cap rate.
- 02Deciding whether this year's cash return justifies the cash you tied up: cash-on-cash return.
- 03Judging a whole hold period with uneven cash flows and a sale at the end: IRR.
- 04Checking whether a lender will be comfortable: debt service coverage ratio, not a return metric at all.
- 05Reviewing a property you already own: all of the above, computed from recorded transactions rather than estimates.
Stated plainly
| Figure | Calculation |
|---|---|
| Cap rate | net operating income ÷ price or value |
| Cash-on-cash return | before-tax cash flow ÷ cash invested |
| IRR | the rate r where Σ cash flowᵢ ÷ (1 + r)^(daysᵢ ÷ 365) = 0 |
Because property cash flows arrive at irregular intervals, IRR must be solved over actual dates rather than tidy annual periods.
How this page is produced
Written against the cash-basis accounting model Property Pulse implements. Formulas are stated in full so any figure can be reproduced by hand; nothing on this page is generated from customer data.
Last reviewed against Property Pulse v0.12.84.