Internal Rate of Return (IRR)

Internal rate of return is the annual rate that makes the net present value of an investment's cash flows equal to zero, purchase, operations and sale included. It is a total return over the holding period. Cap rate approximates it only when NOI does not grow and the property sells at the cap rate it was bought at.

IRR captures what cap rate leaves out: rent growth, expense growth, the mortgage paying down, a refinance, and the price at exit. A property bought at a 6% cap rate with 3% NOI growth and sold at the same cap rate after five years has an unleveraged IRR near 9%. With a 75% loan below the mortgage constant, the leveraged IRR is lower in the early years and depends heavily on the exit.

IRR needs a forecast for every one of those inputs, so it is exactly as reliable as the exit assumption. Many investors target 12 to 15% leveraged IRR on a five to ten year hold. Cap rate is the observable starting point; IRR is the forecast built on it.

Further reading: Internal Rate of Return (IRR) on Wikipedia.