Personally, I always explain to my clients the cash-on-cash formula. After everything is paid for (mortgage, taxes, utilities, etc) you will have a dollar amount at the end of the year. You take that dollar amount and divide it by the amount you originally invested. For example, let’s say after year one you made $10,000 and your original investment was $100,000. $10k divided by $100k = 0.10, or 10%. The reason I prefer this method is because most new to average investors can understand putting their money in a savings account or CD. Most savings pay under 1%, while CD’s pay around 4% (if you’re lucky!). That 10% example won’t hold true every year due to changing vacancy, rents, maintenance (i.e. new roof), etc., but at least you can get a handle on what you are making.
The only time I suggest using IRR is when you plan on having an exit strategy (aka you plan on selling). Most of my clients are buying to hold for an extended period of time. To try and guess what average growth rate/cap rates/loan rates are going to be in 10 years is just too farfetched. I only recommend using the IRR valuation when you plan on selling within 5 years.
Feb 23, 2011