Cash on Cash Return vs ROI vs IRR: Which Return Are You Measuring?

Cash on cash return is one year of cash flow divided by cash invested. Return on investment, as rental investors use the term, adds appreciation and loan paydown to that cash flow. Internal rate of return spreads all of it across the holding period, including the sale, and finds the annual rate that ties it together.

They are three different questions. Cash on cash asks what the property pays you now. ROI asks how much wealth it built this year. IRR asks what the whole investment returned per year from purchase to sale.

The same deal, three answers

A $250,000 rental, 25% down, $75,000 total cash invested, $187,500 loan at 7.25%. Rent $2,600 with standard expenses. First-year numbers:

• Cash flow: $4,756
• Principal paid down in year one: $1,815
• Appreciation at 3%: $7,500

Cash on cash return: $4,756 / $75,000 = 6.3%

Total ROI (year one): ($4,756 + $1,815 + $7,500) / $75,000 = 18.8%

IRR over a five-year hold: roughly 13 to 15%, depending on rent growth, selling costs and the exit price. The cash flows are $75,000 out, five years of rising cash flow in, and a final year that includes the sale proceeds after paying off the loan and 6 to 7% of costs.

Same property. 6%, 19%, and 14%. None of them is wrong. Each includes different things.

What cash on cash return includes

Cash. Rent collected, minus operating expenses, minus every dollar of the mortgage payment, divided by every dollar you spent to get in. It ignores what the property is worth, how much loan you have paid off, and what the IRS lets you deduct.

Its strength is that every input is observable this year. Its weakness is that it misses most of the return on a leveraged property in a growing market. The what is cash on cash return guide covers it in full.

What total ROI adds

Two things, usually. Principal paydown: the part of each mortgage payment that reduces the balance, which is equity you own but cannot spend without selling or refinancing. Appreciation: the change in the property’s value, which is a forecast until you sell.

Some investors also add tax savings. Depreciation on a residential rental spreads the building’s cost over 27.5 years and shelters part of the cash flow from income tax. The value depends on your bracket and on whether you can use the losses, so it is often left out of a first pass.

Total ROI is a better measure of wealth building. It is also a worse measure of safety, because two of its three components cannot pay the mortgage.

What IRR adds

Time and the exit. IRR takes every cash flow from purchase to sale, including the year you buy (negative), each year of cash flow, and the final year with sale proceeds after paying off the loan and closing costs. It finds the single annual rate that makes those cash flows worth zero in today’s dollars. The Wikipedia entry on internal rate of return has the math.

IRR captures rent growth, expense growth, the refinance in year three, the roof in year six, and the price you sell for. It is the metric institutional investors use because it accounts for when money arrives, not just how much.

It also needs a forecast for every one of those things. An IRR is exactly as reliable as the exit price you assumed. Two investors can produce a 9% and a 16% IRR on the same property by disagreeing about appreciation, and neither will know who was right for a decade.

Which one to use

Screening a deal: cash on cash return. Fast, observable, no forecast needed. If the property cannot reach your minimum cash yield on honest inputs, stop.

Deciding whether you can hold it: cash on cash return. Appreciation does not pay the mortgage. Cash flow does.

Comparing a rental against another asset class: total ROI or IRR, with the same time horizon and both stated the same way. Stock returns are total returns. Comparing them to a cash yield understates the rental.

Choosing between two deals with different appreciation profiles: IRR, with the same assumptions applied to both.

Deciding when to sell or refinance: IRR, because it is the only one that knows what year it is.

How they relate

For a leveraged property in a normal market, cash on cash is usually the lowest of the three, total ROI the highest in early years, and IRR somewhere between. If cash on cash is the highest, either appreciation is negative or the loan is being paid down very slowly, both worth a look.

A useful habit: compute cash on cash first, then ask how much of the total return depends on things you are forecasting. If a deal is 6% cash and 13% forecast, you are mostly buying the forecast. That can be a fine choice. It should be a conscious one.

The calculator produces the cash on cash return and the cash flow figure that feeds the other two. For the return you can bank on this year, start there.