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I hope IRR is starting to make sense. Most people simply use Excel to calculate these two metrics using Excel’s embedded formulas, but I think it’s important to have a good understanding of what the formulas are doing and what they output means.
Let’s continue, following Part 2 where we talked about how stock market returns and real estate returns differ.
How to Calculate IRR:
To calculate IRR manually, you would need to find the discount rate that sets the NPV to zero. However, most people use financial calculators or software (e.g., Excel, DealGen) to calculate it because it’s iterative and complex for multiple periods
IRR is calculated using the following formula (don’t fret if this looks daunting, I’ll try to simplify it):
Where:
Ct = Cash flow in period t
t = Time period (in years, months, etc.)
IRR = Internal rate of return
In Excel, the function =IRR (values) can be used, where “values” represent the series of cash flows (negative for outflows, positive for inflows).
How to Calculate IRR
Imagine you’re investing in a small apartment building. Here’s the scenario:
You buy a property for $50,000 today and expect to hold it for 3 years. During that time, you receive rental income every year, and at the end of the third year, you sell the property for a profit. Your goal is to figure out what your overall return on this investment is—this is where IRR comes in.
Here’s the breakdown of the cash flows:
Year 0 (Initial Investment): You invest $50,000 upfront (this is your outflow).
Year 1 (Rent Income): The property generates $5,000 in rent during the first year.
Year 2 (Rent Income): You receive $5,000 in rent again during the second year.
Year 3 (Rent + Sale Proceeds): In the third year, you collect $5,000 in rent and sell the property for $50,000 (the sale price), making your total income for Year 3 $55,000.
So, the cash flows look like this:
Year 0: -$50,000 (negative, since it’s an investment outflow)
Year 1: +$5,000 (positive cash flow from rent)
Year 2: +$5,000 (positive cash flow from rent)
Year 3: +$55,000 (rent + sale of the property)
Now, you want to figure out your IRR, which is the rate that tells you how well this investment performed over the 3 years, factoring in the timing and size of each cash flow.
You don’t need to calculate this manually. You enter the numbers into a financial tool like Excel using the =IRR() function, and it tells you your IRR is approximately 24.89%.
What Does This Mean?
The 24.89% IRR means that, over the 3-year period, the total returns you earned on your investment—including rent and the profit from selling the property—are equivalent to earning 24.89% annually.
This figure includes the value of getting smaller amounts of money back earlier (from rent) and a larger amount later (from the sale).
In essence, IRR considers the timing of when you receive your money. A higher IRR often indicates a more favorable investment because it shows how quickly you’re getting your money back.
So, if you’re comparing this real estate deal to another investment, like the stock market, which might offer a steady 10% return per year, the 24.89% IRR from the real estate deal suggests that this particular property investment could be a more profitable choice over the 3-year period.
Why IRR Matters:
IRR helps you compare investments that have uneven cash flows, like real estate, with other investments that have steady returns, like stocks. It gives you a single percentage that reflects your investment’s overall performance, allowing you to decide whether it’s worth it.
By turning the calculation into a story, we’ve shown how IRR works without needing to dive into complex formulas. It’s a powerful way to make investment decisions when you’re dealing with multiple cash flows over time.
Why Use IRR?:
Time Value of Money: Unlike simple return metrics, IRR accounts for the time value of money. $1 today is worth more than $1 in the future, and IRR adjusts for this.
Cross-Comparisons: It allows investors to compare multiple projects or asset classes on the same scale. A 15% IRR in real estate can be compared directly to a 10% IRR in private equity.
Flexibility: It works well when cash flows are not consistent, which is common in real estate.
Reasons IRR Might Be a Misleading Metric:
Can Be Manipulated by Discount Rates: One of the biggest criticisms of IRR is that it can be influenced by the choice of discount rate, allowing syndicators to make an investment appear more attractive than it really is. By adjusting cash flow estimates or discount rates, the IRR can be inflated to look better on paper. This can lead to IRR being used as a marketing metric, rather than a realistic reflection of returns.
Ignores the Scale of Investment: IRR measures the efficiency of cash flows but doesn’t take into account the size of the investment. A smaller investment might show a higher IRR, but generate less profit overall than a larger, lower-IRR deal. This can mislead investors into thinking they are getting a better return, when in fact, the total profit is much lower.
Relies Heavily on Cash Flow Projections: IRR is only as good as the cash flow projections used in the calculation. If those projections are overly optimistic or unrealistic, the IRR will be artificially high. This can give investors a false sense of profitability, especially in deals where future cash flows (like rent or sale proceeds) are uncertain.
Multiple IRR Solutions: For deals with alternating positive and negative cash flows, there may be multiple IRRs, making it difficult to determine the “true” return. This can add complexity and confusion, especially if investors don’t realize there are multiple potential IRRs.
Insight on Marketing Metric Usage:
You’re absolutely right! IRR is often highlighted by syndicators because it’s an easy-to-understand, headline-grabbing metric. However, as an experienced real estate investor, you know that cash-on-cash return, cap rate, NOI, and other metrics offer a clearer picture of cash flow and overall investment health. IRR can sometimes mask the risks or variability of those other metrics, which is why it’s important to use it in conjunction with more grounded measures of return.
Conclusion:
While IRR is a helpful metric for evaluating the efficiency of cash flows, it should not be the sole metric used for investment decisions. When used without proper context or additional financial analysis (like cash-on-cash return, cap rate, or NOI), it can paint an overly optimistic picture, which is why it can sometimes feel like a “fluff” metric, especially when used as a marketing tool by syndicators.
Teaser for Part 4:
Next, we’ll explore the sensitivity of IRR to cash flow timing. Learn why receiving cash flows earlier can dramatically improve your returns, and how delayed cash flows can shrink your overall gains. Stay tuned for an in-depth look at how timing can make or break an investment!
Reminder:
Missed the first two parts? Be sure to check out Part 1 for an introduction to IRR and NPV, and Part 2 to understand how IRR differs from stock market returns.
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