What is an Internal Rate of Return?

In a previous blog we looked at ‘cash-on-cash’ returns to provide a good measure of immediate and ongoing annual returns an investor can expect.  However, this metric did not take into account an important element…time.  The Internal Rate of Return (IRR) uses the time value of money to better analyze the investment opportunity.  This metric is important because a dollar today is worth more than a dollar tomorrow due to inflation, opportunity cost, and risk.

So, what is IRR?

IRR is defined as a discount rate that makes the net present value (NPV) of all cash flows from a particular project equal to zero.  I will spare you from the formula and calculation, however, Excel’s IRR function will easily compute your IRR on your next investment opportunity.

To keep it simple, let’s look at the scenarios below comparing 4 different investment opportunities.  Each investment opportunity has an initial investment of $50,000 and cash flows differently for years 1-4.  At year 5, the scenarios assume the same sales price for each investment.  With each scenario you will see a different profit and IRR.  If you are more concerned with consistent cash flow you may decide to go with scenario B, despite a lower overall IRR.  However, if you are looking to maximize returns you would likely choose scenario C.

	Scenario A	Scenario B	Scenario C	Scenario D
Year 0 (Initial Investment)	$         (50,000)	$         (50,000)	$         (50,000)	$          (50,000)
Year 1 Cash Flow	$                        –	$              4,000	$              3,500	$               2,500
Year 2 Cash Flow	$                        –	$              4,000	$              4,500	$               3,000
Year 3 Cash Flow	$              6,500	$              4,000	$              5,500	$               3,500
Year 4 Cash Flow	$              7,500	$              4,000	$              6,500	$               4,500
Year 5 Cash Flow	$           75,000	$           75,000	$           75,000	$            75,000
IRR	12.91%	14.31%	15.56%	13.23%
Profit	$           39,000	$           41,000	$           45,000	$            38,500

Three things to consider when evaluating a ‘good’ IRR for your own specific needs:

1. Despite there not being a one-size-fits-all for each multi-family asset class, there are general assumptions on what an asset class can expect for an Internal Rate of Return. With any investment, your returns are directly related to the risk involved with the property as indicated below.
   1. Core: 8%-12% IRR
   2. Value-Add: 12%-18% IRR
   3. Opportunistic: 18%+ IRR

2. IRR will change based on the time it takes you to receive your investment back. A faster return on investment will yield a higher IRR since the metric is computing the time value of money.  Another way to look at it is the longer the opportunity takes to receive your investment the less valuable it is.

3. You should never solely rely on IRR when evaluating an investment. While IRR is the ‘measuring stick’ for private investments, it does have some limitations. Investors need to realize the difference between IRR and annualized returns, in order to make smart investments and real estate decisions. When calculating IRR it is assumed all distributions will be reinvested immediately, which means there is a built-in compounding assumption that actually doesn’t happen.

There is obviously a lot to consider when investing in a property. Knowing all the tools available is crucial to making a good investment. There probably isn’t one perfect calculation, however, educating yourself with all the options and using multiple calculations will ensure you the most accurate evaluation for your investment.

Additional Resources

What Are Cash on Cash Returns? » CREI Partners

The CRE Acquisition Due Diligence Playbook  » CREI Partners

Vetting Real Estate Partners: Invest Safely and Successfully » CREI Partners