Cap rate tells you a property's first-year unleveraged yield. Cash-on-cash return tells you the leveraged yield in year one. Neither captures what most investors actually care about: the annualized return over the entire hold period, including appreciation and the lump sum you get when you sell.
That is what Internal Rate of Return (IRR) does. It is the most complete return metric in real estate, and once you understand it, it changes how you compare deals.
What IRR actually measures
IRR is the annualized rate of return that makes the net present value of all cash flows from an investment equal to zero. Translated to plain English: it is the discount rate at which the money going in equals the money coming out, averaged across the entire hold period and accounting for the time value of money.
A cash flow today is worth more than the same cash flow five years from now. IRR honors that. A 12% IRR means your investment grew at 12% per year, compounded — same yardstick you use to evaluate a stock portfolio or a bond.
The IRR formula
IRR is defined implicitly. There is no closed-form formula — you solve for the rate r that satisfies:
Where CFₜ is the cash flow at time t (negative at t=0 for your initial investment, positive in later years for rent and the eventual sale). Spreadsheets handle this with the =IRR() function. You list the cash flows, hit enter, and Excel iteratively solves for the rate.
IRR vs cap rate vs cash-on-cash
These three metrics answer different questions. Mixing them up is one of the most common analysis mistakes.
Cap rate
NOI divided by purchase price, ignoring financing. Snapshot of year one. Useful for comparing properties to each other and to the market. Read our cap rate calculation guide for the full formula.
Cash-on-cash return
Annual pre-tax cash flow divided by total cash invested. Includes financing. Snapshot of year one only.
Internal rate of return
Annualized return over the full hold, including appreciation and sale proceeds. The complete picture.
A property can have a 5% cap rate, 8% cash-on-cash, and 16% IRR — all at the same time. Each metric is correct; they are answering different questions.
How to calculate IRR with cash flows
Build a year-by-year cash flow table. Year 0 is your initial investment (negative). Years 1 through N are net cash flow from operations. Year N also includes net proceeds from sale.
Year 0: −$75,000 (down payment + closing costs)
Year 1: +$6,000 (cash flow after mortgage)
Year 2: +$6,500
Year 3: +$7,100
Year 4: +$7,800
Year 5: +$8,500 cash flow + $145,000 net sale proceeds = +$153,500
IRR (Excel =IRR): 22.4%
That same property had a year-one cap rate of about 6% and a cash-on-cash of 8%. The 22% IRR comes from leverage, principal paydown, and 3% annual appreciation compounding over five years. None of that shows up in cap rate or year-one cash-on-cash.
What is a good IRR for real estate?
Benchmarks vary by leverage and risk profile. Rough guideposts:
Leveraged residential rentals
Target 15% to 20% IRR over a 5-10 year hold. Below 12% and you are taking real estate risk for a stock-like return. Above 25% usually means high leverage, value-add work, or a hot market that will not last.
Unleveraged (all-cash) buys
Target 6% to 10% IRR. You lose the leverage multiplier but also the financing risk. This is what institutional buyers and 1031 exchange parking deals often run.
Value-add and BRRRR projects
Target 20%+ IRR. You are taking renovation and refinance risk and should be paid for it. See our BRRRR strategy guide for the full playbook.
Syndications and commercial
LP investors typically see 13-18% projected IRR over 5-7 years. Anything above 20% projected deserves heavy skepticism on assumptions.
Limitations of IRR
IRR is powerful but not perfect. Three things to know.
1. It assumes reinvestment at the same rate
IRR mathematically assumes every dollar of cash flow gets reinvested at the IRR rate itself. If you cannot find another 22% deal to plow your monthly cash flow into, your real-world return will be lower. Modified IRR (MIRR) fixes this by letting you set a separate reinvestment rate.
2. It can be misleading on short holds
A property held one year that earns a 50% return reports 50% IRR. A 10-year hold at 15% IRR builds far more wealth in dollar terms. Always look at IRR alongside total dollars made (equity multiple).
3. Garbage in, garbage out
IRR depends entirely on the assumed exit price. If your sale-year assumption is wrong, your IRR is wrong. Always run sensitivity analysis on the exit cap rate.
Putting it to work
Build an IRR model on every deal you take seriously. Even a rough 5-year projection — operations, appreciation at the local market rate, sale at a reasonable exit cap — beats relying on cap rate alone.
If you finance the deal, also model debt math on the Mortgage Math Lab to lock in your debt service inputs. And remember that IRR is pre-tax — your after-tax IRR depends on depreciation, your bracket, and where you live; TakeHomeTax can help you model the personal income side.
IRR is harder to calculate than cap rate, but it is the closest thing we have to one-number truth in real estate investing.
IRR worked example: 5-year hold with sale
Consider a $200,000 rental property purchased with 25% down ($50,000 plus $6,000 closing = $56,000 cash invested). Conventional financing at 7%. Estimated cash flow of $300/mo year one, growing 3%/yr with rents. Sold at year 5 for $232,000 (3% appreciation/yr). After selling costs (6%) and remaining mortgage payoff (~$144,000), net sale proceeds ~$74,000.
The cash flow series:
- Year 0: −$56,000 (initial investment)
- Year 1: +$3,600 (operating cash flow)
- Year 2: +$3,708
- Year 3: +$3,819
- Year 4: +$3,934
- Year 5: +$4,052 + $74,000 sale proceeds = +$78,052
Plugging that series into the IRR formula (most spreadsheet apps have an IRR() function), the result is approximately 11.4% IRR. That single number captures cash flow, appreciation, principal paydown, and the time value of money — none of which cap rate or cash-on-cash return shows individually.
Why IRR makes the decision clearer
That 11.4% is comparable to other investments on equal terms. A stock portfolio expected to return 9% IRR over the same period would underperform this rental. A bond ladder at 5% IRR would underperform substantially. IRR's strength is exactly this comparability — across asset classes, across deal structures, across hold periods.
IRR's limit: assumes reinvestment at IRR
The classic IRR critique: it assumes intermediate cash flows are reinvested at the IRR itself, which is rarely realistic. For a rental returning 11.4% IRR, you'd need somewhere to put the year-1 $3,600 cash flow that itself earns 11.4%. If you put it in a savings account at 4%, your actual realized blended return is lower than the calculated IRR. Modified IRR (MIRR) addresses this with explicit reinvestment-rate assumptions.