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Understanding Internal Rate of Return (IRR)

Apples to Apples: Understanding the Internal Rate of Return (IRR)

The internal rate of return, or “IRR,” is the percentage that reflects what any individual investment is expected to yield from inception to sale.  It takes into account anticipated cash flow and appreciation, as well as the time value of the capital invested.

Knowing when and how to calculate IRR can help you make better, more successful investment decisions.

IRR and the Limits of “Cap Rates”

When considering cash-flowing real estate investments, commercial real estate professionals use a “cap rate”, or rate of return, to compare unrelated properties to one another.

(Click here to read my column further describing the use and calculation of cap rates.)

There are limitations. For example, a cap rate based on present income is not particularly helpful when:

  • a property hasn’t finished construction
  • the property has substantial vacancy
  • the property will undergo further development to significantly change the projected income stream

In such cases, you should evaluate properties based on their anticipated value once improvements are complete and the property achieves a stabilized occupancy and cash flow.  You may also wish to compare the projected (or actual) overall return for different investments, including proceeds from the sale of the property.

This is when you need the internal rate of return to help execute such comparisons.

Definition and Example of Internal Rate of Return (IRR) in Action

Working Definition:

Internal Rate of Return (IRR) indicates what the present value of your return would be equivalent to if it generated a consistent annual cash-on-cash return over the life of the investment.

Example of Internal Rate of Return:

An investment with an IRR of 14% is an investment that will have returned a sum by the end of the investment period that will be equivalent to receiving a 14% annual cash-on-cash yield.

It does NOT mean that you will actually receive 14% at any particular point in time.  

In fact, you may receive no cash flow whatsoever for several years and then receive a lump sum upon sale of the asset. This makes up for the time spent waiting for your return. An IRR takes into account the value of an investment in today’s dollars (another definition of IRR is the discount rate that will make the net present value of an investment equal to zero).

So if the current interest rate is at 5.0%, $100 today would be equivalent to $105 a year from now ($100 + $5 interest), and $110.25 two years from now ($105 + $5.25 interest). IRR takes this time value into account. However, IRR does not tell you how much cash you are actually expected to receive in hand on a monthly, quarterly, or annual basis, nor does it tell you how long it is likely to take to achieve your returns.

For example, all of these investments have the same IRR of 10.0%:

Initial Investment

Return Year 1

Return Year 2

Return Year 3

Return Year 4

$100,000 $20,000 $30,000 $40,000 $40,000
$100,000 $10,000 $10,000 $35,000 $84,000
$100,000 $0 $0 $0 $145,000

 

If you are looking at an investment opportunity that projects an IRR:

Remember that the IRR is simply an educated guess about what will occur if certain assumptions are satisfied. Those assumptions may include the amount of time needed for construction or leasing, achievable rents and occupancy rates, project costs, the type of financing available for the project, and market conditions at the intended time of sale. Changes in any of these factors will affect your actual returns.

Accordingly, you must look beyond the IRR to assess the underlying risks of the investment and to understand why one investment may have a greater projected return than another.

About Tracy Treger

Tracy is a Principal at Syndicated Equities where she helps high net worth individuals and family offices to profitably invest in real estate. She also assists investors in identifying appropriate replacement property to complete tax-deferred exchanges under Section 1031 of the Internal Revenue Code. Drawing upon her 20 years of legal experience in the areas…

Continue Reading Bio »   •   View all articles by Tracy Treger »

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