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Why IRR Matters: Evaluating Real Estate Investment Returns

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What is IRR (Internal Rate Return)?

One of the most common metrics used to gauge investment performance is the Internal Rate of Return (IRR). It is one of the first performance indicators you are likely to encounter when browsing real estate crowdfunding opportunities.

Typically expressed in a percent range (i.e. 12%-15%), the IRR is the annualized rate of earnings on an investment.

A less shrewd investor would be satisfied by following the general rule of thumb that the higher the IRR, the higher the return; the lower the IRR the lower the risk. But this is not always the case.

While there is no concrete definition tying asset class to IRR, the following IRR ranges can be generalized as follows.

  • Core: 8% – 12% IRR
  • Value-Add: 12% – 18% IRR
  • Opportunistic: 18+% IRR

But there are several crucial factors to consider when evaluating what makes a “good” IRR for your own needs. This article will break down:

  • The math behind IRR.
  • How IRR and net profits vary based on when cash flow is distributed.
  • Why the IRR should never stand alone when you’re evaluating an investment.

IRR 101: The Mathematics

IRR is closely tied to another investment metric, the Net Present Value (NPV), which is essentially the difference between an investment’s market value and its total cost1. To understand IRR, we must first understand NPV.

Net Present Value

Any investment with a positive NPV will make money, just as any investment with a negative NPV will lose money. When looking for a real estate deal to invest in, you are only going to be presented with deals where the sponsor is projecting a positive NPV, as no one is going to bring a deal to market that is expected to lose money. But how would a sponsor determine if their proposed deal has a positive projected NPV?

For example, let’s say you are evaluating whether to invest in the value-add repositioning of an apartment community. To calculate NPV, the sponsor would first look at what comparable renovated properties are selling for — that’s the market value. Next, the sponsor would estimate the cost of buying, renovating, operating and selling the property — that’s the total cost. If total cost is less than the market value, they have found a positive estimated NPV.

Ok, Back to the IRR

Above we simplified IRR as the “annualized rate of earnings on an investment.” Now that you have a better understanding of NPV, we can present a more telling definition of IRR and look at how it’s calculated.

IRR = The interest rate that makes the NPV equal to zero

Put another way, an IRR is the interest rate that makes the market value and total cost equal. To determine IRR, we can take the NPV calculation below, define NPV as zero and solve for “r”.

Done yet?

Luckily, Excel does the calculation for us, enable a quick determination of IRR based on cash distribution over a projected period. Below is an illustration of how IRR works for a $25,000 investment in a project with a projected hold period in the 5 year range.

The table in orange on the left gives a quick overview of the cash flow over the five years, which for this particular scenario equates to an IRR of 13.94%. The right hand side in blue shows what is going on behind the scenes for each year in terms of the Return On Investment and the Return Of Investment. An investor would earn $15,000 in net profits over five years in Scenario A. Not bad, right?

Not All Equal IRRs are Equal

Well, imagine if the IRR was closer to 21%, and the investor could have seen a net profit of $15,000…wait, what? That’s right, a deal with the same investor net profit can have a varying IRR depending on when the cash flow is distributed. Take a look at Scenarios “A” through “E” below.

While all five scenarios have the same net profit of $15,000, the IRR values range from 13.94% to 26.22%. The scenarios with cash flow weighted towards the beginning of the hold period (“D” and “E” above) will end up having higher IRRs, as the metric is essentially the “time value” of money.

Just as deals with the same investor net profit can have different IRRs, deals with the same IRR can have wildly different profits. This is demonstrated by Scenarios “F” through “I” below.

Now is one scenario above better than another? It really comes down to what you are looking to get out of the deal. Scenario “I” might have the lowest investor net profit, but the investor is getting the vast majority of their investment back and Year 1 and could put those funds to work somewhere else. Scenario “A” is perfect for someone who has no need for that money for a few years, and they are rewarded for their patience with a higher net profit.

So what does this all mean for an investor looking to get involved with real estate through crowdfunding? The IRR is just one metric to examine when performing due diligence on a commercial real estate investment opportunity. When combined with other metrics — such as the Equity Multiple, in particular — the IRR can paint a much more accurate picture of how the investment is expected to perform.

Footnotes:
[1] Ross, Stephen A., Randolph Westerfield, and Bradford D. Jordan. Essentials of Corporate Finance. Boston, MA: McGraw-Hill/Irwin, 2004. Print.

The ArborCrowd TeamWhy IRR Matters: Evaluating Real Estate Investment Returns