The Metric Confusion
Ask most real estate investors which metric matters most and they'll say cap rate. Ask the sponsors who have made (and lost) fortunes in real estate and they'll say IRR.
Both are right — for different purposes. Here is how to use each correctly.
Cap Rate: A Snapshot in Time
Cap rate measures a property's current income relative to its value:
Cap Rate = Net Operating Income / Property Value
A $2M apartment building generating $120,000 in NOI has a 6% cap rate.
When cap rate is useful:
- Comparing similar assets in the same market
- Benchmarking pricing against recent transactions
- Understanding current yield without leverage
When cap rate misleads you:
- Value-add deals with below-market rents (the "going-in" cap is artificially low)
- Markets with different rent growth trajectories
- Any deal where you care about total return over time
IRR: A Full-Cycle View
IRR (Internal Rate of Return) accounts for the time value of money across the entire investment:
- When you receive distributions (earlier is better)
- What price you sell at (the "exit" is often 40-60% of total return)
- How long your capital is tied up
A deal with a 4% cap rate in a high-growth market can deliver a 22% IRR if rents double and you sell at a compressed cap. A deal with an 8% cap rate in a declining market can deliver a 6% IRR if rents fall and you're forced to sell at a higher cap.
The Hidden IRR Killer
Most investors miss the biggest IRR destroyer: hold period extension.
If a sponsor projects a 5-year hold and it extends to 8 years, your IRR drops significantly even if the absolute return is the same. Here is a simplified example:
| Scenario | Total Return | Hold Period | IRR |
|---|---|---|---|
| Base case | 2.0x | 5 years | ~15% |
| Extended | 2.0x | 8 years | ~9% |
Same money, very different return on your time.
What to Look For
For passive investors evaluating a deal:
- Use cap rate to sanity-check acquisition pricing vs. market comps
- Use going-in cap vs. exit cap spread to stress-test the sale assumption (a deal that assumes compressing from 5.5% to 4.5% is making a bold bet)
- Use IRR to understand your actual expected return — but discount it by 15-20% from whatever the sponsor projects, because projections are optimistic by nature
- Use equity multiple as a simple cross-check (1.8x or better over 5 years is reasonable for moderate risk)
SkAI Does This Automatically
When you upload a deal to SkAI, we extract the projected cap rates, IRR assumptions, and equity multiples — then compare them to market benchmarks so you know whether the underwriting is aggressive, conservative, or in line with comparable transactions.
You see the full picture in one view, not spread across 60 pages of a PPM.