# Understanding Internal Rate of Return (IRR) in Real Estate Investing

The Internal Rate of Return (IRR) is the rate at which each invested dollar is projected to grow for each period it is invested.

## What is an Internal Rate of Return (IRR)?

IRR, or the internal rate of return, is defined as the discount rate at which the net present value of a set of cash flows (ie, the initial investment, expressed negatively, and the returns, expressed positively) equals zero.   In more simple terms, it is the rate at which a real estate investment grows (or, heaven forbid, shrinks).  In this sense, you can think of it as a time-sensitive compounded annual rate of return.

## Why IRR is Useful

The IRR is useful because it can provide an “apples-to-apples” comparison of two cash flows with different distribution timing.  To help illustrate the concept, consider the following three examples.

## Examples of IRR

#### Example 1 – The Coupon

The first example is a typical debt investment with regular distributions and no upside or downside participation 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 sale of the property.

 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%.  The investment grows by 10% per year evenly.

#### Example 2 – The Annual Pref with Upside

In the second example, we add in some upside on sale.  In this case, the operational cash flows are still regular, allowing for 8% annual distributions; however, there is participation in the profits from 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.  This is because of the time value of money.

#### Example 3 – The Value-Add

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.  In the first year there is no operating income, and in years 2 and 3 half of the operating income is held in reserve for tenant improvements as the lease up occurs.  The building reaches stabilization in year 4 and is sold in year 5.  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.

A real estate investor presented with only the IRR, without knowing anything else about distribution schedule or business plan, would not be able to conclude which deal is best suited for his/her investment criteria. One of the keys to IRR analysis, though, is realizing that timing plays an important role. The time or duration of the investment hold period and the timing that cash distributions are paid to investors both have a big influence on this equation.

### 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. How an investor 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 is important for investors to look below the surface to see the terms and assumptions used to derive the IRR as well as also consider desire for operational distributions.  That is why investors often use IRR in conjunction with other metrics when analyzing the merits of a particular real estate investment offering.  In our next article, we will show how investors can quickly learn a lot about an investment simply by comparing the IRR to the average cash-on-cash return and the equity multiple.

### A note on CrowdStreet’s standards

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.  On the CrowdStreet Marketplace, all IRR targets are net-to-investor unless explicitly stated otherwise.

Also, it has become fairly standard in the industry to calculate the IRR on an investment based on an annualized roll-up of what might actually 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, actually, 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”. The point is that when comparing IRR’s across multiple deals, be sure to check the type of IRR calculation for each deal to avoid falling prey to this potential trap. On the CrowdStreet Marketplace, all IRR projections are calculated on an annualized basis unless explicitly stated otherwise.

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