### What is an Internal Rate of Return (IRRThe Internal Rate of Return (IRR) is the rate at which each invested dollar is projected to grow for each period it is invested. It differs from other metrics in that it accounts for the concept of the “time value of money”, or the fact that a dollar received and reinvested elsewhere today is worth more than a dollar expected... More)?

In simple terms, IRR is the rate at which a real estate investment grows (or shrinks) over time. The key distinction between IRR and the other frequently cited return metrics is that IRR accounts for not only how much profit is anticipated but also when those profits are anticipated. The calculation of IRR incorporates the concept of the “time value of money,” the idea that a dollar today is worth more than a dollar tomorrow. This is caused by inflation’s eroding effects (assuming inflation is increasing), opportunity cost, and risk. You can think of it as a time-sensitive compounded annual rate of return.

### Why IRR is Useful

First, you should note that the IRR should not be seen as the investment metric but rather as one of several important metrics you can use to evaluate real estate investments. The targeted IRR is helpful because it can provide an “apples-to-apples” comparison of two cash flows with different distribution timing. One of the keys to IRR analysis is realizing that timing plays an important role. The time or duration of the investment hold period and the timing of when cash distributions are paid to investors both have a significant influence on this equation.

To help illustrate the concept, consider the following three examples.

Example 1 – The Coupon

The first example is a typical debt investment with regular distributions and no rights to participate in additional profits upon sale (nor exposure to downside risk if the sale price is lower than anticipated) and no fee upon sale. In this example, the investment is in a stabilized property that receives 10% annual distributions until the return of capital at the end of year-5 after the property’s sale.

 Year 1 Year 2 Year 3 Year 4 Year 5 Initial Initial Investment -\$10,000 Operation Cash Flow \$1,000 \$1,000 \$1,000 \$1,000 \$1,000 Return of Capital \$10,000 SUM -\$10,000 1,000 \$1,000 \$1,000 \$1,000 \$11,000 IRR 10%

This sort of regular payment schedule is sometimes referred to as a coupon because of its regularity (bonds used to have physical, detachable coupons which investors would redeem), and in this case, it is the same as the IRR—10%, meaning the investment grows by 10% per year evenly.

Example 2 – The Annual Pref with Upside

In the second example, we’ll add in some upside upon the sale.  In this case, the operational cash flows are still regular, allowing for 8% annual distributions; however, investors are also given a share of the profits from the sale in year 5.

 Year 1 Year 2 Year 3 Year 4 Year 5 Initial Investment -\$10,000 Operation Cash Flow \$800 \$800 \$800 \$800 \$800 Sale Profit \$1,220 Return of Capital \$10,000 SUM -\$10,000 \$800 \$800 \$800 \$800 \$12,020 IRR 10%

Here, the IRR is the same as the first example—10%.  Despite receiving less cash during the first four years, the two investments accumulate returns over the 5-year term at the same rate.  Notice that it takes more cash to achieve the same IRR thanks to the time value of money.

In this final example, we replace the 8% annual distributions with irregular payments. Suppose the business plan is to renovate and re-tenant an office building. There is no operating income in the first year, and in years two and three, half of the operating income is held in reserve for tenant improvements as the lease-up occurs. The building reaches stabilization in year four and sells in year five. The distributions look like this:

 Year 1 Year 2 Year 3 Year 4 Year 5 Initial Investment -\$10,000 Operation Cash Flow \$0 \$400 \$400 \$800 \$800 Sale Profit \$3,410 Return of Capital \$10,000 SUM -\$10,000 \$0 \$400 \$400 \$800 \$14,210 IRR 10%

Again, the IRR is the same as the first two examples—10%.  Again, the investment accumulates wealth for the investor at the same rate over the same time period despite having zero income in the first year and less income in years 2 and 3.

Again, the IRR is the same as the first two examples—10%. The investment accumulates wealth for the investor at the same rate over the same time despite having zero income in the first year and less income in years two and three.

### Why a larger IRR isn’t always the goal

It is often assumed that bigger is better—a 15% IRR is more attractive than a 10% IRR. However, one of the problems with using an IRR analysis is that it can be misleading if used alone. Without knowing the distribution schedule or business plan, IRR alone is not enough information to conclude which deal is best suited for your investment objectives.

How an investment reaches that IRR also can be an important factor to consider when comparing real estate investment opportunities. While a bigger IRR might look good at face value, it’s important to look below the surface to see the terms and assumptions used to derive the IRR and consider the desire for operational distributions. For example, minor adjustments in the annual rent growth assumptions or the cap rate used in the projection of the assumed sale price could result in meaningful changes to the projected IRR. This is one way the IRR is subject to “financial engineering” (more on this below).

Another thing to keep in mind is that IRR is not without limitations. IRR does not account for the project’s size or risk profile, nor does it account for unplanned future costs or “surprises”. That is why investors often use IRR in conjunction with other metrics when analyzing the merits of a particular real estate investment offering, including cash-on-cash and the equity multiple.

As we’ve seen, there are ways to manipulate the IRR based on how you calculate targeted returns. For instance, a sponsor might present a project-level IRR; however, this rate of return is not an apples-to-apples comparison with a net-to-investor IRR because it does not take into account sponsor fees and promotes. In the cases where there are fees or promotes, the project-level IRR will be greater than the net-to-investor IRR, meaning the investor stands to receive less than what the project-level IRR might seem to represent.

Also, it has become relatively standard in the industry to calculate the IRR on an investment based on an annualized roll-up of what might be monthly or quarterly distributions. Namely, the calculation assumes that cash flow is distributed once per year. This is done to make the presentation of material simpler, avoid confusion about how the IRR is calculated for any given deal, and provide the most conservative interpretation of a series of annual targeted cash flows. Given the time-sensitivity of the IRR, increasing the frequency of the distributions in the calculation (to quarterly or monthly) will increase the number and change it to a different formula known as an XIRR. This is one of the industry tricks that, when abused, can sometimes be labeled as “financial engineering.”

When comparing IRRs across multiple deals, be sure to check the type of IRR calculation for each deal to avoid falling prey to this potential trap.