How it’s Calculated: Cash on Cash Returns vs. Internal Rate of Return (IRR) vs. Average Annual Return (AAR)
You’ve heard that real estate comes with high ROIs, but how do we get those numbers? And what do they mean?
Let’s take a look at a few standard metrics for measuring real estate returns: Cash on Cash Returns, Internal Rate of Return (IRR), and Average Annual Return (AAR)
Cash on Cash Returns
The cash-on-cash metric helps investors evaluate current and potential profits. It can help you assess how each investment affects your portfolio’s big picture. While cash-on-cash returns are the simplest way to evaluate investment performance, it does not consider appreciation or principal debt payments.
Here’s how you can calculate your investment’s cash on cash return.
Cash On Cash Return = (Annual Cash Flow / Initial Cash Outlay ) x 100%
Let’s use the following example. Imagine your annual cash flow (your real income after deducting expenses) is $12,000, and your initial cash outlay (initial cash investment) was
$100,000. The cash on cash return in this case would be ($12,000 / $100,000) x 100% = 12% Many investors agree that you should aim for a cash-on-cash return of 8% or higher.
Internal Rate of Return (IRR)
While cash on cash returns focus more on the portfolio as a whole, an internal rate of return is used to calculate anticipated profit over a set period.
IRR can help you understand what kind of returns are generated from each dollar invested, and it considers how time affects a dollar’s value (i.e., a dollar is worth more today than it will be tomorrow.)
To understand your IRR, we have to consider the concept of discounting, compounding interest that works backward in time. To calculate the future value of an investment, the following formula can be used:
Future value = Present value (1 + interest rate) # of compounding periods
For commercial investments, many investors aim for around a 20% IRR.
Average Annual Return (AAR)
The average annual return is similar to IRR in that it measures performance over time, but it does not consider the time value of money.
To calculate your AAR, you can take your annual cash on cash returns for each year and divide for the average.
Let’s consider the following examples:
Add all the cash on cash returns to total 83 percent for 2019 through 2022. Divide by four years, and the annual average return on this investment is 20.75%.
Which investment return metric is the best to use?
It’s important to note that no individual metric should guide your investment decisions. Instead, multiple methods should be used to evaluate a potential property’s usefulness. Getting comfortable with each metric on its own and how it fits into the bigger picture can help you have a more holistic understanding of how your investments are doing.