Measuring a deal’s internal rate of return (IRR) is a mainstream way to assess an investment opportunity. The IRR endeavors to express what someone will earn on investment over the course of the total holding period, taking into consideration likely changes in income, property value, and debt service. IRR reveals the full return on a project, though they may fluctuate from year to year, on an annualized basis.
In short, IRR is a value that expresses the sum of all future cash flows according to when they transpire in time. The more immediate the earnings from an investment are received, the higher the IRR. Functionally, the IRR is used by investors and businesses to find out if an investment is a good use of their money.
How is IRR Determined?
Working out IRR is moderately intricate. It is a conceptual topic that weighs the time-value of money and the rate of profit the investment generates over its entire life cycle. According to the basic time-value of money principle, a dollar collected today is worth more than a dollar earned in the future given inflation, among other things. The IRR is essentially a way to discount earnings obtained in the future. The further in the future profits are, the less valuable they become.
Therefore, to ascertain IRR, you first need the yearly cash flows, the investment property is forecasting to produce or has produced. The cash flows include both: (1) cash flow from rent; and (2) cash flow from the sale of the property. You must know how much cash flow is coming from each for the IRR calculation.
The hurdle with determining IRR is that it can be tricky, even for the most sophisticated investors, to forecast anticipated cash flows and sales yields. As such, more conservative investors will only use actual numbers to gauge a realized IRR instead of predicted.
A few other things to note about IRR:
· The sooner the same earnings from an investment are received, the higher the IRR.
Consequently, a project with a higher IRR does not fundamentally imply it’s a “better” investment than a different opportunity. A higher IRR could translate into the same cash flow received, but at a more immediate point in time. A project with a lower IRR could have better returns, but later in time. Both alternatives can provide favorable outcomes.
· IRR calculations do not factor the risk profile of a project or other variables that could conceivably impact overall returns.
Why is IRR Important?
IRR is a fundamental metric in that it can be used to supplement cap rates. Unlike cap rates, which only use the first-year NOI and purchase price, or the terminal value and NOI as static views of value and return, the IRR estimation factors in NOI for multiple years, and considers purchase price and sales proceeds, and looks at broader and overall returns on investment.
IRR enables investors to examine investment opportunities across the board, not just those in commercial real estate, and provide an avenue for leveraged returns to be analyzed. Totting up IRR helps to evaluate funds flow over various periods to their net present value, thereby applying the economic concept of ‘time-value of money.’ In short, this concept stipulates that a dollar today is worth more than a dollar tomorrow, due to inflation, opportunity costs, and inherent risks. Using IRR to figure out the discount rate of cash flows (DCF) ensure each cash flow is given appropriate weight by discounting that cash flow by the time-value of money.
Many investors also like utilizing IRR because it does not require a “hurdle” rate, such as the rate of capital investment or cost of capital. IRR can be added up independently, and investors can then associate their individual estimated price of money to the IRR as they so choose (as the cost of capital can vary broadly depending on the investor’s profile, amount of equity in the deal, banking relationships, and more). More seasoned investors might use a modified internal rate of return (MIRR) to account for these complications.
When to Use IRR
There are different circumstances in which investors would want the IRR to discover the potential profitability of an investment.
IRR is a particularly useful tool in that it considers the term of the investment, which is valuable when looking at short to medium term investments, or those that have a fixed period and projected exit strategy. For smaller projects, such as two and four-family home investments, knowing the cap rate alone might suffice. But for more significant projects, like Class A apartment communities that have institutional or international investors in the deal, there is likely to be a set term upon which the investors are expecting to be repaid. In conditions like these, determining a projected IRR is imperative, and the only way to get to that number is by also planning an exit cap rate – so both tallies are needed.
As noted above, any investor who wants to examine investment possibilities, including the cost of capital, will want to use IRR, as IRR can be weighed both with and without leverage. This is a stark contrast to cap rates, which never factor in debt. Different properties underpin various leveraged amounts and types of debt, which is why IRR provides a vital perspective to cultured investors.
Conclusion
The IRR can be an invaluable tool for assessing returns in a project. Nevertheless, even the best mathematical determinations have deficiencies. For instance, IRR assumes that all positive cash flow is reinvested at the same rate of return as the IRR, which is often not the case. There could also be years with negative cash flows, where significant capital improvements are needed or if there’s a substantial disruption in cash flow due to fire, natural causes, etc.
In any event, it is difficult to predict the future, and therein lies the challenge. We don’t have a crystal ball and cannot precisely foretell what rent growth will be or what a sales price will be. Therefore, with these regards, even IRR calculations are imprecise.
That said, reckoning a property’s IRR is a necessary step in any investor’s underwriting process. Many investors feel uncomfortable running the numbers on a deal, and reasonably so—there are many determinants to consider, overlook a line item, and your numbers could prove fatally flawed. When in doubt, always consult your CPA or retirement advisor before investing in any commercial real estate deal.