Internal Rate of Return (IRR)
Last year, we wrote a blog post about the basics of the Internal Rate of Return (IRR) calculation. Today, we will explore IRR further. IRR is one of the metrics of choice for many real estate investors because it takes into account the time value of money using discounted cash flow analysis. Investors should think of IRR as the projected rate of growth an investment can potentially generate.
Overview of IRR – What You Should Know
In any investment opportunity, investors are not only interested in how much money they would potentially receive, but when they would potentially receive it. The IRR calculation is a key aid for investors in evaluating investment opportunities because it helps to equate funds flow over different periods to their net present value, thus applying the key underlying concept of the time value of money. This concept holds that a dollar today is worth more than a dollar tomorrow, due to inflation, opportunity cost, and risk.
The IRR is the discount rate that will bring a series of cash flows to a net present value of zero (or to the current value of cash invested). In order to calculate IRR, investors must understand the concept of discounting. It can be viewed simply as compounding interest in reverse – that is, compounding interest working backwards in time. By assigning projected cash flow distributions on a periodic basis (along with any projected gain on sale upon exit/at reversion), we can calculate IRR.
IRR and Real Estate Investments
Evaluating IRR for real estate investments is a very important tool for investors to analyze different projects. It is important to note the advantages and disadvantages of using IRR to analyze real estate investments:
Advantages of IRR
- Time Value of Money – The timing of all future cash flows are considered; therefore, each cash flow is given an appropriate weight by discounting the time value of money.
- Simplicity – IRR is an easy metric to calculate and it provides a simple means by which to compare various real estate projects.
- Hurdle Rate Not Required – IRR does not require the use of a “hurdle” rate (i.e., the cost of capital, or required rate of return at which investors agree to fund a project), mitigating the risk of determining a vastly divergent rate. IRR can be calculated independently of the use of such rates, and investors can then compare their own individual estimated cost of capital to the IRR as they choose.
Disadvantages of IRR
- Ignores Size of Project – Cash flows are simply compared to the amount of capital outlay generating those cash flows. This can be a disadvantage when two projects require a significantly different amount of capital outlay.
- Doesn’t Account for Unplanned Future Costs – Like most analytical tools, IRR only concerns itself with the projected cash flows and may not reflect unplanned future costs that may adversely affect profit. It is up to the investor to make sure that the pro forma projections adequately reflect, or reserve against, such “surprise” costs.
- Ignores Reinvestment Rates – Although IRR allows you to calculate the value of future cash flows, this calculation is based on the assumption that those cash flows can be reinvested at the same rate as the IRR. This may be an unrealistic assumption if the IRR is high, as opportunities to reinvest at such return rates may not in fact be available.
The IRR metric is used to aid the due diligence process and assists investors in evaluating real estate opportunities. Due diligence considers the physical, financial, legal, and social characteristics of a property and its expected investment performance. Before settling on a set of cash flows and sales figures that are key in calculating IRR, investors must thoroughly evaluate the various inherent risks in a property and the different assumptions made. While there is still no computerized substitute for thorough human evaluation of the various factors that might affect an investment’s outcome, conducting due diligence and pre-vetting real estate opportunities is essential. Investors must always be aware of the various risks involved with any investment opportunity before making final investment decisions.
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