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COMMON INVESTMENT METRICS
Capitalization Rates (CAP Rates) are quick and easy metrics used to determine the attractiveness of a first-year net return on investment.
Cap Rates are quick and easy to calculate which makes them one of the most commonly used metrics. Cap rates work well in long-lease-term, net investments where year-to-year income and expenses are unlikely to change much.
Cap Rates lack scope as they only look at the first year of investment. They also ignore capital improvements and the effects of financing.
Return On Investment (ROI) measures the return over the entire project from start to finish - what you put in and what you get out.
ROI factors in the only parts you really care about, the money you put out and the money you get out, encompassing all cash flows over the project period. Not to mention, it's quick and easy!
ROI ignores the time factor of the project (e.g. 50% return over one year vs 50% return over 100 years). Several variations of the formula exist which often results in discrepancies when comparing with others. ROI relies heavily on predictions which can often be unreliable in long-term projects.
The Internal Rate of Return (IRR) is the annual rate of growth a project is expected to generate over an estimated holding period.
IRR is the most all-encompassing of these three metrics, looking at the entirety of the project including periodic cash flows and time value of money. IRR is presented as an annualized rate of return which is simple to interpret.
Much like ROI, IRR relies on predictions of the future which may be unreliable. IRR also requires a calculator and detailed periodic cash flows to compute which makes it less user-friendly. The IRR assumes the reinvestment of cash flows at the same rate which isn't always feasible.