In this next installment of our private equity real estate terminology series, we’re going to take a look at one of the most important – and potentially confusing – investment metrics: the internal rate of return.
The Internal Rate of Return, or IRR, is the discount rate that makes the net present value of all cash flows for a given investment equal to zero.
For those of us without a finance degree, the IRR is the annual rate of growth an investment is expected to generate throughout its lifetime.
“Wait a minute, Josh,” you protest. “Didn’t we just cover the annual return in your wonderfully informative and well-written piece on the cash-on-cash return?”
An astute observation, dear reader! You are correct that the cash-on-cash return allows investors to determine the yearly cash flow as a percentage of the upfront cost of an investment. However, the IRR doesn’t just take yearly cash flow into account – it accounts for all of the cash flows associated with the asset over the entire lifespan of the investment, including terminal value. While the cash-on-cash return as well as the cap rate metrics are snapshots in time, the IRR is a more comprehensive, longer time horizon metric. As we’ve stated before, real estate investors don’t just make money from yearly cash flows – they also expect their asset to appreciate, and if they use leverage to acquire property, they will also generate a return through paying down debt over time. By looking at an investment’s projected IRR in addition to its cap rate and cash-on-cash return, real estate investors achieve a much more holistic picture of the return profile.
In order to illustrate this principle, let’s look at a few simple examples.
Let’s imagine a scenario in which we purchase a property for $1 million. The building is stabilized, and based on historical financials, we confidently expect to generate $100k in cash flow per year for ten years, at which point we plan to sell it for $1 million. As such, the IRR is 10% - there was no change to the terminal value, and the yearly cash-on-cash was 10%, so the cash-on-cash is equal to the IRR.
Now let’s look at another scenario. In this deal, we’ll also buy a building for $1 million, but it’s in rough shape, has multiple vacancies, and only makes $50k a year in net income. However, we’ve done our homework, and we know that if we spend $100k upgrading the property during the first year of ownership, we’ll be able to collect significantly more income in future years.
As we can see, if we were to evaluate the property based on income in year one, this appears to be a terrible investment – we spent $100k and collected $50k, for a year one loss of $50k. However, as a result of our investment, we were able to collect $150k in net income in year two of ownership, and we increased income by 3% per year through year ten. Then, we sold the property at an 8% cap rate based on year ten income for a total IRR of 18.15%.
How to use IRR
So is it always better to pursue higher IRR deals? Not necessarily. While one of IRR’s main features is the fact that it provides a holistic picture of performance over the life of the investment, the number evaluated in a vacuum provides no visibility into the sources or timing of those cash flows, or how safe or speculative they are.
For example, imagine we’re considering the investment in our first example, where we’re buying and selling for the same price, but collecting a stable stream of income along the way for an IRR of 10%.
Now imagine that another opportunity comes across our desk with a projected IRR is 20%. On the surface, this sounds like a far more attractive investment – 20% is greater than 10%, after all. However, when we ask to see the cash flow projections, we see the following:
Having dug into the numbers, we see that the entirety of the return is generated via an assumption about the terminal value of the asset in year ten and that there is no cash flow generated along the way. We may still decide that this is our preferred investment – perhaps it’s an opportunity to acquire an incredible piece of land in a market that we feel is going nowhere but up – but we also may decide that the first option with an IRR of 10% is a better fit for our investment goals and our risk/return appetite, even though it’s a lower overall return.
How to calculate
Unlike a cap rate or a cash-on-cash return, IRR is difficult to calculate without the aid of a spreadsheet. Here is the formula to calculate IRR manually:
Fortunately, you can simply open up an Excel file, enter “=IRR”, select your cash flows, and Excel will run the math for you.
IRR is an essential tool for any private equity real estate investor to be able to use and understand. As we have seen, it is important to not simply look at the IRR as a number, but to understand the assumptions that are driving the metric. However, when deciding between investments of the same type, it is likely the single best metric on which to base your decision. Coupled with other metrics, IRR helps investors achieve a more complete picture of investment performance.
Fortunately, you can simply open up an Excel file, enter “=XIRR”, select your cash flows and dates, and Excel will run the math for you.