Cap Rate vs IRR: Follow a Complete Property Cash-Flow Model

Trace a property from rent to sale proceeds. Reproduce cap rate, unlevered IRR and equity IRR, then test exit cap rates, income growth and borrowing costs.

One property can have a 6.3% entry cap rate, a 6.6777% unlevered IRR and an 8.0599% equity IRR. None of those numbers has to be wrong. Each follows a different portion of the money over a different span of time.

The useful question is how to reconcile them. We will follow one hypothetical property from its rent roll through its operating costs, loan payments and sale. Then we will change the sale assumption and the borrowing cost while keeping the rest of the model intact.

Every assumption below is illustrative. The figures are not market averages, current loan quotes or predictions. The cap-rate tool handles the income-to-value ratio; the IRR workspace lets you inspect the complete investor schedule.

Begin with income that belongs to the property#

Suppose the purchase price is $800,000. First-year scheduled rent is $72,000, the vacancy allowance is $3,600, and operating expenses are $18,000.

The expenses in this example cover property taxes, insurance, management and routine maintenance. Debt service and investor income taxes are outside this NOI measure. We also keep annual capital work separate so its cash effect remains visible.

Definitions of reserves and capital allowances can differ between reports. Reconcile the actual line items before comparing two stated NOIs. The OCC's commercial real estate lending handbook discusses income analysis, capitalization and the need for clear assumptions; its glossary defines capitalization rate using stabilized NOI and sale price. Here we explicitly use our stated first-year NOI and purchase price. See printed pages 42–43 and 138 in the OCC handbook.

A 6.3% entry cap rate means the stated annual NOI is 6.3% of the purchase price. It does not include acquisition costs, the mortgage, capital work or a later sale. It therefore cannot tell you the investor's complete annualized return.

State the costs and financing before calculating IRR#

The full model uses these assumptions:

This is a deliberately simple annual model. It excludes investor income taxes, additional financing fees, prepayment penalties and unexpected capital work. Interest-only financing is a stated scenario, not a claim about available terms. A real monthly amortizing loan would require its own payments and remaining balance.

The initial equity requirement is $260,000, rather than the $240,000 difference between price and loan, because the investor also pays acquisition costs. Leaving those costs out would overstate the return.

Follow the five years of cash flows#

Annual equity operating cash equals NOI minus the $4,000 capital expenditure and the $33,600 interest payment. There is no annual principal amortization in this particular loan.

The final year needs another reconciliation. A buyer paying a price based on forward NOI would use the modeled year-six income, even though the seller receives only five years of operating cash.

Forward year-6 NOI = 50,400 × 1.02^5 = 55,645.67248128
Gross sale price = 55,645.67248128 / 0.063 = 883,264.64256
Selling costs = 883,264.64256 × 3% = 26,497.9392768
Net sale after costs and debt = 883,264.64256 - 26,497.9392768 - 560,000
                             = 296,766.7032832

Add that net sale to the year-five operating cash. Do not count the sale twice, and do not subtract the original loan instead of the actual remaining balance in a model with amortization.

The annual equity IRR is 8.05994147%. At a hypothetical 10% equity discount rate, NPV is -$20,159.62. The schedule produces positive nominal cash gain, but does not meet that assumed 10% hurdle.

To reproduce the result, paste these unrounded model amounts into the IRR workspace in annual mode. Displayed table rows round independently to cents.

-260000
12800
13808
14836.16
15884.8832
313721.2841472

If those six amounts occupy cells A2:A7, =IRR(A2:A7) reproduces the periodic calculation. For actual uneven payment dates, build the dated schedule and use XIRR instead. This annual simplification aggregates payments at year-end, so it is not an exact reconstruction of monthly rent and debt payments. Microsoft IRR, Microsoft XIRR.

Remove the financing and compare the same property#

To find the unlevered return, the investor pays all $820,000 of purchase and acquisition costs. Each year's property cash flow is NOI less capital work. At sale, deduct selling costs but no loan balance. Nothing about the property's operating performance or sale price changes.

The annual unlevered IRR is 6.67773033%. It differs from the 6.3% entry cap rate because the complete schedule includes acquisition costs, capital work, income growth and net sale proceeds. It differs from the 8.0599% equity IRR because the equity investor uses the stated loan.

Borrowing improves equity IRR in this base scenario. That observation is conditional on these cash flows and loan terms. It is not a rule that debt always improves returns, or that the interest-rate-to-cap-rate spread alone establishes a good financing decision.

Change one assumption and inspect what moves#

The following scenarios use the same $260,000 initial equity and five-year horizon. Each changes only the item named in its first column. All other inputs remain at the base values.

The exit cap changes price through division. A lower denominator produces a higher price for the same forward income. Changing the exit cap leaves the five operating distributions unchanged; only net sale proceeds move. There is no fixed dollar loss or IRR reduction associated with every 0.5-point cap-rate increase across all properties.

Flat income changes two parts of the model. Annual operating cash falls relative to the base forecast, and the income used to value the sale stops growing. With NOI fixed at $50,400, operating equity cash is $12,800 each year; the final receipt adds $216,000 of net sale proceeds.

More expensive debt affects every year. An 8% interest-only rate costs $44,800 annually, which is $11,200 more than the base loan. Subtract that extra expense from each of the five equity receipts. The principal payoff and property sale price remain unchanged. The lower 3.9867% equity IRR shows why a higher borrowing rate can reverse the benefit that appeared in the base scenario.

These are sensitivity results, not probabilities or worst-case limits. Several assumptions can worsen together. The cases help identify what drives a result; they do not measure the likelihood of those conditions.

Make two cap rates comparable before choosing one#

An entry cap calculated from trailing income and an exit cap applied to projected income use different numerators. Write both definitions beside the rates. In this model, the entry rate uses first-year NOI; the exit rate uses forward year-six NOI. Applying 6.3% to year-five NOI instead would produce a different sale value.

When comparing actual properties, match the income period, vacancy treatment, recurring expenses, reserves and property condition. A difference in cap rates may reflect a difference in what was counted. A market benchmark also needs a documented geography, property type and observation period. The hypothetical rates here cannot serve as that evidence.

For IRR, distinguish cash already received from assumptions about future cash. Performance projections remain hypothetical; their apparent precision does not verify the forecast. Investor.gov: Performance Claims.

Use the comparison to find the next useful question#

The entry cap rate helps describe a stated income-to-price relationship. The complete cash-flow model lets you examine how costs, financing, income changes and exit value affect the investor. Neither replaces the work of validating the inputs.

For this example, the question worth investigating is why the sale should be valued at the selected exit cap and whether 2% annual NOI growth is supported. Changing either can move the result more than adjusting the displayed return's final decimal place.

Use the cash-flow reference library for smaller cases on timing, fees and ambiguous returns. Use the IRR versus NPV guide when comparing projects of different sizes, and the guide to evaluating an IRR to examine the hurdle and forecast behind a proposed return.

All numerical examples above are constructed models checked by independent discounting and root calculations. They are not actual property performance, current lending terms or professional investment review. This revision replaces unsupported market ranges and incomplete financing examples with one reconciled model.