Understanding IRR
IRR 101
Understanding Internal Rate of Return
IRR As a Tool to Research Investment Opportunities
There is no single metric that will by itself fully characterize the prospects of an investment opportunity. When an investor evaluates a real estate deal, they should analyze multiple aspects of the investment to determine its worthwhileness. One metric that should be incorporated when researching an investment opportunity is Internal Rate of Return, or IRR.
IRR is an approximation for the annualized return across the period of performance for a particular deal. It takes into the account the time-value-of-money, so projects that produce larger cash flows earlier in a period of performance will have larger IRRs than projects that only return cash flows later. To illustrate this nuance, Table 1 illustrates an example where an investor contributes $50,000 to an investment at year 0, and through the 5-year investment, various cash flows are returned. In all 3 scenarios, the investment ultimately returns $100,000 at year 5, thus 2x the initial investment amount. This example will illustrate how a 2x return over a 5-year period, can have different annualized returns based on how cash flow distributions are made across the period of performance.
Table 1: The Effects of Cash Flow Distributions on IRR
In Scenario 3, the investment returns an annual amount of $5,000 (or 10% of the principal amount) between years 1 and 4. In year 5, the investment returns a final distribution of $80,000 to ultimately 2x the initial investment amount. The IRR in this case is 17.1%.
In Scenario 1, there are no distributions in years 1 through 4, but in year 5 the investment returns a payment of $100,000.
In both cases, an initial investment of $50,000 turned into $100,000 in 5 years, but in Scenario 3, distributions occurred early and periodically through the investment period. This example illustrates that for an investor, money now is better than money later. It also illustrates that IRR can be used to compare returns between various return profiles, such as a more stable cash flowing multifamily investment versus a development project, which could have no cash flows until the development is sold.1
While IRR is a powerful tool that should be included in every underwriting process, it has limitations that if understood will ensure investors are more informed and able to make savvy investment decisions. According to John Kelleher and Justin MacCormack, in an article from the McKinsey Quarterly, and commenting on the limitations of IRR, they say:
“Practitioners often interpret internal rate of return as the annual equivalent return on a given investment; this easy analogy is the source of its intuitive appeal. But in fact, IRR is a true indication of a project’s annual return on investment only when the project generates no interim cash flows, or when those interim cash flows can be invested at the actual IRR.”2
To Further illustrate Kelleher and MacCormack’s point, Table 2 highlights Scenario 3 from the previous example. In Scenario 3, if each of the cash flow distributions in years 1 through 4 are subsequently reinvested in an opportunity that returns the calculated IRR of 17.1% year-over-year, then the IRR of 17.1% is in fact the individual investor’s true annualized return. However, let’s say the investor from Scenario 3, more realistically takes each of the cash flow distributions from years 1 through 4, and reinvests the money into a S&P 500 index fund that returns 10% year-over-year. In that case, the Modified Internal Rate of Return, MIRR, calculation is a more appropriate metric to consider and derive an annualized rate of return, and in this case a better approximation for the annualized return is 16.1%.
Table 2: Using IRR to Calculate Annualized Return
IRR and MIRR are powerful tools an investor can use to compare various deals against one another, or help an individual investor better understand how a particular deal affects their investment strategy. Business developers will throw attractive numbers at possible investors, and it is the responsibility of the individual investor to understand all aspects of a deal.
1. The Definitive Guide to Underwriting Multifamily Acquisitions: Develop the Skills to Confidently Analyze and Invest in Multifamily Real Estate, Robert Beardsley, 2020, Page 66.
2. Internal Rate of Return: A Cautionary Tale, John C. Kellehher and Justin J. MacCormack, The McKinsey Quarterly – 2005 Special Edition: Value and Performance, Page 73.
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