Internal Rate of Return

Internal Rate of Return, or IRR, is often used to showcase how profitable a deal is. However, it can be difficult to understand what it actually means. IRR is defined as the discount rate at which the net present value of a set of cash flows (i.e., the initial investment, expressed negatively, and the returns, expressed positively) equals zero. In simple terms, it is the rate at which your investment grows. To illustrate this, let's look at some examples:

Example 1:

In the initial scenario, we have a conventional debt investment involving regular distributions without participation in potential gains or losses, and without any fees upon the property's sale. Specifically, the investment is made in a stabilized property that yields 10% annual distributions until the return of the invested capital, anticipated at the end of the fifth year following the property's sale.

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Example 2:

Imagine the strategy involves refurbishing and re-leasing an office building. During the initial year, there is no operating income. In the subsequent two years, half of the operating income is set aside for tenant improvements during the leasing process. By year 4, the building achieves stability and is subsequently sold in year 5. The distribution schedule is as follows:

As you can see, both examples have the same IRR of 10% but have very different cash distributions. If a real estate investor is provided only with the IRR and lacks details about the distribution schedule or business strategy, they cannot determine which investment aligns best with their criteria. However, a crucial aspect of IRR analysis is recognizing the significance of timing. The duration of the investment hold period and the timing of cash distributions to investors both exert a significant impact on this calculation. It's commonly believed that higher is better—a 15% IRR seems more appealing than a 10% IRR. However, relying solely on IRR can be misleading. How the IRR is achieved is crucial when comparing real estate investments. While a higher IRR may seem attractive initially, investors should scrutinize the underlying terms, assumptions, and operational distribution preferences. This is why investors often combine IRR with other metrics to thoroughly evaluate real estate investment opportunities.