Real estate sponsors will often use the term “IRR” to boast about their deal’s potential returns. Yet most passive real estate investors don’t fully understand what this jargon means. IRR is a metric used to calculate a deal’s internal rate of return and is a common way to value an investment opportunity. The IRR attempts to express what someone will make on an investment over the course of the entire holding period, taking into consideration potential changes in income, property value, and debt service.
In this article, we take a deeper look at how and why IRR is used, how it can be manipulated, and whether the IRR is the most appropriate metric to use when evaluating passive real estate investment opportunities.
What is IRR?
There are a few metrics investors will commonly use to make an apples-to-apples comparison of one deal versus another. One of these metrics is a deal’s internal rate of return, or IRR. The IRR is the average rate of return a project will generate over the duration of the holding period, inclusive of all cash flow, refinancing, and disposition proceeds.
One of the reasons investors find IRR a tricky concept to grasp is that it relies on forecasting future cash flows, which requires some degree of assumption since market conditions can change in the blink of an eye (case and point: COVID-19). What’s more, IRR applies a discount rate to those future cash flows, an abstract topic that relies on the time value of money. It is a much more complicated metric to use (and understand) than other metrics, like cap rates. We’ll compare IRR to cap rates in more detail below.
How to Calculate the IRR of Passive Investments
As noted above, calculating IRR is a complicated affair that relies on a forecast of future cash flows, which in turn can be affected by general market conditions, risk, cap rates, and other assumptions.
There are two economic principles involved in calculating IRR. The first is the opportunity cost of capital theory. The IRR assumes there is an opportunity cost to making one investment versus another and therefore, tries to factor that into the calculation. The second is the time-value of money principle, which assumes a dollar received today is worth more than a dollar received in the future given inflation. The IRR is essentially a way to discount earnings received in the future. The further into the future earnings are, the less valuable they become.
Therefore, in order to calculate IRR, you must calculate the deal’s projected yearly cash flows. 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.
It can be difficult, even for the most sophisticated investors, to forecast future cash flows and sales proceeds. This is easier to do when investing in a stabilized property, in which case there is a history of cash flows to rely upon. It’s also easier to calculate when you intend to have a short holding period, as it’s much easier to predict what a property will be worth three years from now versus 15 or 20 years down the road. New construction and value-add deals will want to closely compare their deal to comps in the local marketplace to get a realistic understanding of what future cash flows may be. A common misstep is for investors to overestimate future cash flows, which has a dramatic impact on the resulting IRR.
Why a High IRR Isn’t Always a “Better” IRR
An important note about using IRR to evaluate passive real estate investments: the sooner the earnings from an investment are received, the higher the IRR will be.
What that means, then, is that a project with a higher IRR does not necessarily equate to a “better” investment than another. Two deals could generate the same amount of cash flow, but the deal with a higher IRR will generate cash flows at an earlier point in time. Conversely, a project with a lower IRR could actually have better overall returns, but will generate those returns at a later point in time. For example, a quick flip will likely have a significantly higher IRR than a 10-year hold, however the whole dollars received by the investor will likely be materially less.
Factoring in Equity Multiples
In order to adjust for the fluctuations of IRR and time, investors will typically use IRR in conjunction with an “equity multiple”. An equity multiple looks at the multiples of cash that are received over the duration of the holding period, including interest payments and cash flow distributions. The equity multiple is expressed as a ratio of investment returns to the capital paid into a project.
The equity multiple is easy to calculate. Here’s the formula to use:
- Equity Multiple = Total Cash Distributions / Total Equity Invested
For example, if an investor puts $200,000 into a deal for five years, they’ll have a total equity investment of $1 million. If, during that time, the deal generates $2 million in cash distributions, the equity multiple will be 2.0x. In other words, for every $1 invested, the investors gets back $2 (including their initial investment). This does not consider property appreciation.
Here’s why the equity multiple matters when looking at a deal’s IRR: An investor might put $100,000 into a deal and, after a quick flip, might get $110,000 back. On paper, this deal might have a high IRR but the equity multiple would only be 1.10x. The investor will want to consider whether this deal, and any associated risks, are worth this 10% return.
How to Manipulate IRR in Real Estate Deals
A dirty little secret, if you will, about IRR is that these calculations can be easy to manipulate. Because quick gains have an outsized influence on the IRR calculation, sponsors may strategically manage cash flows to inflate projected returns. For example, a sponsor might use leverage to delay capital calls. By using a credit line instead of a capital call, the sponsor can then report a higher IRR without materially impacting the deal’s fundamentals.
See, most sponsors work on a pay-for-performance model. Many do not receive a return until their fund achieves a certain threshold, such as an 8-10% IRR. By utilizing a credit line, rather than investor equity, the sponsor can increase the IRR needed to reach the preferred returns sooner, thereby collecting their payouts quicker, too.
This sort of financial engineering is a red flag, and may be a sign that the sponsor is working in their own best interest rather than in the best interests of their investors. It’s also why IRR should just be one of many metrics (such as the equity multiple) that investors use to analyze a deal’s potential profitability.
Using IRR vs. Cap Rates
Another metric commonly used to evaluate the profitability of real estate deals is the capitalization rate, or “cap rate”.
The cap rate is expressed as a percentage, usually between 3% and 20%, and can vary depending on asset class, quality and location, market timing and more. Cap rates have an inverse relationship to property value – the higher the value, the lower the cap rate, and vice versa. Furthermore, “safer” deals tend to have lower cap rates compared to “riskier” deals. Depending on an investor’s risk profile, they may be drawn to deals with higher or lower cap rates.
A property’s cap rate is derived by dividing the unlevered net operating income (NOI) by the price or total cost of the building. For example, a building purchased for $10 million that generates $500,000 in net income will be said to have a 5% cap rate.
It is important to understand that debt is not part of the cap rate calculation. Cap rates always assume a property is purchased for cash, and for this reason, provides a good comparison of deals without debt skewing the numbers. Naturally, how a property is ultimately financed will drastically impact the deal’s overall returns.
The most important distinction between cap rates and IRR are that cap rates provide only a snapshot of the value of a property at a given moment in the investment lifecycle, whereas IRR provides for an overall view of the total returns on the investment on an annualized basis. Cap rates are like looking at a photograph whereas IRR is like watching an entire movie. Both contain information, but IRR tells a more robust story.
Why IRR is Used by Passive Real Estate Investors
When evaluating various opportunities, it is important for investors to do their due diligence. This includes comparing deals using a variety of metrics. IRR is an important metric that can be used to supplement both equity multiple and cap rate calculations. Unlike cap rates, the IRR factors in NOI for multiple years, leverage, and both the purchase and sale prices.
Another benefit to using IRR is that it does not require a “hurdle” rate, such as the rate of capital investment or cost of capital. The cost of capital, for example, can depend on many factors like the sponsor’s profile, the amount of equity in the deal, banking relationships and more. More sophisticated sponsors might also provide a modified internal rate of return (MIRR) to account for these hurdles.
Knowing When to Use IRR
There are different situations in which investors would want to the IRR to determine 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 three-family home investments, knowing the cap rate might suffice. But for bigger projects, like Class A apartment buildings that have institutional investors in the deal, there is likely to be a set term upon which the investors are expecting to be repaid. In situations like these, calculating a projected IRR is essential and the only way to get to that number is by also projecting an exit cap rate – so both calculations are needed.
As noted above, any investor who wants to compare investment opportunities including the cost of capital will want to use IRR, as IRR can be calculated both with and without leverage. Different properties support different leverage amounts and types of debt, which is why IRR provides an important perspective to passive investors.
Conclusion
The IRR can be a great tool for evaluating a deal’s potential. Of course, it has its shortcomings. For example, it assumes 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, such as when major capital improvements are needed.
In any event, it is difficult to predict the future and therein lies the challenge. It can be difficult to predict future rent growth or what the end sales price will be. Therefore, even sophisticated sponsors may use IRR calculations that are a bit imprecise.
Nevertheless, IRR is a critical metric for any passive investor to understand. It is one of the most commonly used tools for projecting returns, and as such, investors should know both how it is calculated and how it stacks up against other metrics.
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