INCOME RATE OF RETURN
In a previous blog, I talked about Cash on Cash Equity Rate of Return (ERR) on real estate investments. Another formula commonly known to real estate investors is Cash on Cash Income Rate of Return, or just Income Rate of Return (IRR). Unlike ERR, IRR does not factor in principal reduction on a mortgage nor does it factor in equity appreciation. The IRR means the amount of cash flow from an investment in any year, usually the first year, compared to the amount of cash down payment made by the investor.
To calculate IRR, you take the cash flow before taxes and divide it by the inital investment to get a percentage rate of return for the year on the investment.
For example if a real estate investor put down $30000 on a real estate investment and at the end of the first year of operation the property produces a $3000 positive cash flow before taxes then the IRR is the cash flow before taxes divided by the $3000 down payment which equals a 10 per cent cash on cash IRR.
This formula is widely used by investors in the investment real estate market and can be compared to the dividend on a stock, the interest payment on a bond or the equity dividend rate used in real estate appraisal.
Although this is a useful formula, it should be noted that it fails to consider the following:
The tax consequences of net sale proceeds at the time the property is sold.
The variation in cash flow amounts.
The time intervals of cash flows.
Principal reduction on the mortgage.
Appreciation in value.
Cash benefits from refinancing.
Tax consequences on cash flow during holding period.
However, no real estate investment analytical formula is perfect and the IRR is useful for trying to gauge the annual percentage rate of return on a given real estate investment.
Hope you find it useful. Have an great day!