Cash-on-Cash Return, Cap Rate, IRR, ROI: Which is More Accurate in Determining the True Value of a Triple Net Investment?

Oct 14, 2021 | Blog, CRE - Commercial Real Estate, Triple Net - NNN or Net Net Net

Many commercial real estate investors don’t see the true value of or use the cash-on-cash return, cap rate, internal rate of return (IRR), and return on investment (ROI) measurements when considering triple net (NNN) investment properties. However, knowing these calculations can be the difference between ending up with a profitable property versus one that underperforms, or worse, ends up costing money.

Before you invest, get to know the difference between these calculations and utilize the figures to determine if an investment has the potential you think it does as you go forward with your property search.

  • Cash-on-Cash Return measures pre-tax cash flow against your initial investment and shows what percentage of your initial investment is being returned to you on an annual basis.
  • Cap Rate simply compares the purchase price of the property to the income (rent) it generates.
  • IRR gives you the yearly return on equity after adjusting for expenses, rents, loan payments, and tax opportunities.
  • ROI measures how much profit is made on an ongoing basis.

two people calculating internal rate of return for real estate

NNN Cash-on-Cash Return

When you obtain financing to acquire a NNN investment, measuring the cash-on-cash return (CoC) will give you an idea of you how fast you can recover your initial investment. CoC measures pre-tax cash flow against your initial investment and shows what percentage of your initial investment is being returned to you on an annual basis.

To earn the highest cash-on-cash return, try to secure the best financing terms available since a low interest rate can positively affect your CoC and the long-term value of the investment.

To determine the CoC return, first, calculate the amount of pretax cash flow (rent minus debt service). Then divide that by the amount of cash initially invested (down payment).

NNN Cap Rate

You will see all NNN properties for sale advertised with the cap rate, or capitalization rate, usually between 5.50% and 7.00%. This number is the level of equity return on your investment for a single year. A higher cap rate, which would indicate slightly more risk, typically provides a better ROI. A lower cap rate, which correlates to lower risk, will provide less ROI.

In an all-cash deal on an absolute NNN property with zero landlord expenses, the cap rate compares the purchase price of the property to the income (rent) it generates, therefore, the cap rate is your ROI.

Example: $100,000 (Net Operating Income/Rent Received)/$1,667,000 (Purchase Price/CMV) = 6.00% Cap Rate

If you should take out a loan for the property, there is something called the “cap rate spread,” which is the difference between the combined nationwide cap rate and the current interest rate. It is a measure of the risk-and-reward premium for commercial real estate (CRE) investing. You can learn greater detail about the cap rate spread and debt yield here.

NNN Internal Rate of Return or “IRR”

In a nutshell, the IRR provides the yearly return on equity after adjusting for expenses, rents, loan payments, and tax opportunities. The upfront IRR calculation is valuable when searching for a property or working your exit plan, as it identifies your potential annualized return based on educated estimations. A positive IRR indicates a return on your investment. A negative IRR suggests a potential loss.

The expense-free nature of most NNNs and the ability to write off depreciation and interest, when combined with other financial benefits, can turn a 5.00–6.50% capitalization rate (cap rate) into a 7–10% IRR.

Don’t forget the 1031 exchange when calculating your IRR. When done on time and within the IRS’s rules, you can defer all capital gains tax and depreciation recapture tax on the sold property, which also plays into your profitability.

Overall, the internal rate of return is a far better indicator of your true return after you take into consideration the value when sold. The IRR shows you in real dollars, from the beginning to the end of your investment time period, what you gained or lost after completing the sale of the property. To learn the details of how to calculate the IRR of a property, be sure to read our dedicated IRR blog.

Using informed estimations of net present value (NVP) and IRR, the annual IRR should be close to or better than your predictions, providing a healthy annual income and return when you decide to sell.

Man on a colorful chart with the arrow going up

NNN Return on Investment or Cash Flow

With NNN properties, the return on investment or “cash flow” calculation is much the same as any other type of investment vehicle. The ROI measures how much profit is made on an ongoing basis from the investment’s performance. It is a straightforward calculation – net profit divided by total cost of investment. In an absolute NNN lease property cash transaction, your ROI is simply the cap rate, or rent received, as there are typically no landlord expenses.

Westwood Logo in blue/goldTo Wrap it Up – Understanding the Different Types of Profit Calculations Helps When NNN Property Shopping

Even if you are not new to CRE investing, the profit calculations on triple net lease properties can be different than what you’re used to – much less complicated and easier to forecast, but just as important.

No matter what your level of investment experience, before you purchase, instead of just looking at an advertised cap rate, understand the different calculations – cash-on-cash return, cap rate, IRR, and ROI – and use them to find the NNN property that best fits your long-term financial goals. Yes, you can do this on your own, but it’s time-consuming and often leads to investing in the wrong property.

To buy the best property for your goals based on these calculations and the real, uninflated value, engage a Westwood Net Lease Advisor to help. We’re here for you before the property search through closing and thereafter, at no cost to you. Contact us today for a free, no-obligation conversation. 314-997-5227


 

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