Capitalization rates and internal rates of return are both tools that can be used to measure the return of an investment. A capitalization rate expresses the income from an investment relative to its price, usually by looking at a single period of income. Internal rates of return, usually abbreviated as IRRs, take a more holistic view of an investment. They're more complicated to calculate but can be more telling.
To calculate a capitalization rate, you divide the price of an investment into its income. For instance, if you were going to buy an investment for $100,000 and you think you can earn $8,000 a year in profit after subtracting your expenses from your gross income, you would divide $100,000 into $8,000 to come up with 0.08, or 8 percent. Cap rates traditionally exclude the impact of debt and usually don't look at how much money you plan to gain or lose when you sell the investment.
Internal rates of return attempt to express what you will make on an investment over its entire life, taking into account changes in income, gains or losses on your sale and the impact of any debt you use as a part of the purchase. The IRR expresses returns, which may vary from year to year, on an annualized basis. Calculating an IRR requires advanced math but is relatively easy to do using a spreadsheet. For example, consider a $100,000 investment that offers an $8,000 yearly return for which you take out a $75,000 loan. If the loan has a 7 percent interest rate and 30-year life, you'd spend $5,988 on annual payments, leaving you with $2,012. To calculate an IRR for this investment in a spreadsheet, you'd start by entering -25,000 in Cell A1, since you start the investment by putting $25,000 down. In cell A2, you enter $2,012, as that's your profit for your first year ($8,000 in return minus $5,988 in loan payments). In cell A3, you might enter $2,172 as your second year profit, assuming your income goes up a bit. Cell A4 would hold your return for year three -- $2,332. If you sell the property for $110,000 at the end of year four, you'll combine three factors for that year -- your income from the investment, your loan payoff and your proceeds from the sale. Assuming that your income goes up another $160, you will combine $2,492 with the $110,000 sale proceeds and subtract your remaining loan balance of $71,606. This adds up to $45,886, which you enter in cell A5. To calculate the IRR, you enter "=irr(a1:a5)" in cell A6 and come up with an IRR of 19 percent.
Static vs Dynamic
The two types of analyses are very different. A cap rate looks at a return relative to a single moment, while an IRR looks at your return over an entire investment. It's almost like the difference between a photograph and a movie. Both contain information, but the IRR sums up more information over time.
Making Metrics Meaningful
Both metrics have a basic shortcoming: They're only as good as the information you put into them. A cap rate will tell you what the returns were for a given period or, if you project earnings, can tell you what they'll be for a period in the future. IRRs are almost always based on future projections. In either case, if your projected data are bad, your return estimates will be wrong. When looking at historical data, if you select a period that isn't representative of an investment's true performance, you'll also get a misleading result. With this in mind, using either metric is a mixture of art and science.
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