Measuring Returns: Understanding How IRR Works
When considering an investment in a multifamily property, one of the first questions that an investor may ask themselves is, “If I invest in this property, what is the return I can expect on my investment?”
IRR is designed to measure the compound annual rate of return an investor can expect on their investment…
To illustrate this concept, consider the following series of cash flows. Assume a purchase price of $1MM, annual net cash flows of $50,000 and a sale for $1.2MM at the end of a 6 year holding period (year 6 also has $50,000 cash flow). It looks like this:
To calculate the IRR, it’s easiest to put the cash flows in a spreadsheet and use the function for IRR to calculate the answer. Doing so returns the discount rate at which the NPV of this series of cash flows is equal to $0. It’s ~7.7%.
To check this, use the same series of cash flows with the NPV function. For the discount rate, use the answer to the IRR function and, if you’re right, the answer should be $0
Pros of Using IRR as a Tool for Measurement
IRR is a good metric to account for the time value of money, which is the concept that a dollar received today is worth more than a dollar received in the future, due to its earning potential. This is where the time component comes in.
In addition, IRR is a simple metric that can be used to compare investments of a similar time horizon. For example, if you’re trying to decide between three different properties with the same holding period, IRR is a good way to compare the return potential for each. This isn’t just limited to comparing real estate investments, IRR can also be used to compare non-traditional investments (like real estate) to traditional ones like stocks or bonds, as long as the time horizon is the same.
While IRR is useful, it isn’t perfect. When using IRR, there are a few limitations to be aware of.
Cons of using IRR as a tool for Measurement
Further, IRR doesn’t measure the absolute return on an investment. For example, a $100M investment that returns $105M in 1 month works out to an IRR of ~80%, which seems great. But, the absolute return is just $5M, which isn’t as good.
For these reasons and others, IRR is best used as one of several metrics to compare investment opportunities. To illustrate this idea, let’s look at an example.
To calculate the Net Present Value of this opportunity, a discount rate is required. The discount rate that results in a Net Present Value of $0 is the internal rate of return.
Rather than go through the complicated math of the calculation, it’s easiest to use the IRR function in a spreadsheet to calculate the answer. The input would look like this:
=IRR(Cash Flow 0, Cash Flow 1, Cash Flow 2, Cash Flow 3, Cash Flow 4, Cash Flow 5)
The result is 14.78%. If the IRR exceeds the cost of capital by an acceptable margin than it’s an indication that the project may be worth pursuing. But remember, the IRR only makes sense if the income and expenses on the proforma are reasonable and accurate.
Glossary of Key Terms
Internal Rate of Return (IRR): The rate of return earned on each dollar, for each period of time that it’s invested in. It’s calculated as the rate that sets the Net Present Value of an investment’s cash flows (positive or negative) equal to zero.
Net Present Value (NPV): The present value of a series of cash flows is the current value of a future stream of income given an expected rate of return. Thus, the Net Present Value is the difference between the present value of future cash inflows and future cash outflows.
Holding Period: An investor’s holding period is defined as the amount of time for which they plan to hold an investment. It’s usually expressed in either months or years.
Time Value of Money: A financial concept which dictates that a dollar available today is worth more than a dollar available in the future, due to its ability to earn interest. It’s the fundamental concept behind IRR.
Cost of Capital: For a multifamily syndicator or lead partner, the cost of capital describes the total blended rate required to acquire funds for the project. If only debt is used, it may be equivalent to the interest rate on the debt. However, if some combination of debt and equity is used, it would be the blended cost of both.