Part 4 of 7: “The Time Game: How Cash Flow Timing Can Make or Break Your IRR”

Why Timing Matters (Hint: It Can Make Your IRR Look Way Better)

Ever wonder why some investments look like they’re hitting it out of the park but don’t feel that way in the end? A lot of that comes down to timing. A high IRR can make a project look golden simply because you’re getting cash back fast, even if the total profit over time isn’t all that impressive. It’s kind of like eating dessert before dinner—you think you’re winning, but the main course hasn’t even shown up yet!

Real Estate Scenario

Let’s say you’ve got $50,000 burning a hole in your pocket and you invest it in a real estate deal. Here are two ways the cash flow could play out, and both scenarios end with the same total return. But there’s a twist—how that money comes back to you changes everything

Scenario 1: The “Get Paid Early, Look Like a Genius” Route (High IRR)

• Year 0 (Initial Investment): -$50,000

• Year 1: +$45,000 (Almost all your money back through a refinance)

• Year 2: +$5,000 (A little rental income icing on top)

This setup gives you an IRR of over 80%. The early cash flow makes you feel like a financial wizard. But hold on—there’s more to the story.

Scenario 2: The “Steady Eddy” Approach (Lower IRR)

• Year 0 (Initial Investment): -$50,000

• Year 1: +$15,000 (Rental income)

• Year 2: +$20,000 (More rental income)

• Year 3: +$15,000 (Rental income + sale proceeds)

Same total return as Scenario 1, but the IRR is around 25% because you’re getting your cash back slowly. It’s like a slow clap that eventually turns into applause.

Why Timing Matters:

• In Scenario 1, the big, early payout inflates the IRR and makes the deal look like it’s throwing off mad returns.

• In Scenario 2, the returns are spread more evenly, so the IRR is lower, but you’re still walking away with the same pile of cash.

In both cases, the equity multiple (which measures your total profit relative to your initial investment) is the same, but IRR loves early cash flows like a kid loves candy. So, just because your IRR is high doesn’t mean the deal is actually better.

Key Takeaway:

A high IRR can sometimes be like a magic trick—it looks amazing but might not be as real as it seems. You’ve gotta look at other metrics like the equity multiple or NPV to get the full picture of what you’re dealing with.

Discounting Future Cash Flows: Real Estate vs. the Stock Market

Let’s be honest—money today is worth way more than money tomorrow, mostly because you can reinvest it, buy more stuff, or at least brag about having it. That’s where IRR comes in. It makes sure we account for the fact that cash you get sooner is more valuable than cash you have to wait for (patience is overrated, right?).

Real Estate Example:

In real estate, cash flows are all over the place—rents here, a big payout there, and maybe a refinancing check somewhere in between. IRR loves this because it can make those early flows look really good.

• Early Cash Flow Magic: Get $45,000 in Year 1? That’s gonna supercharge your IRR. That money is worth more than cash you’ll see in Year 5 because you can put it to work sooner. In that real estate deal where you threw down $50,000, getting most of it back early will boost your IRR to over 80%.

Stock Market Example:

Now, the stock market plays it straight. Invest $50,000 in an index fund, and you’ll get your 10% return every year, like clockwork, without any big spikes or dips. Boring? Maybe. Predictable? Absolutely.

• Year 1: +$5,000 (10% growth)

• Year 2: +$5,500 (Another 10%)

No rollercoasters here, just a nice, steady climb.

Why This Matters:

1. Timing & Reinvestment: In real estate, getting money back earlier makes IRR look like a superstar. But let’s be real—it doesn’t mean you’re walking away with more in the end. The stock market’s steady 10% gives less room for magic tricks but more predictability.

2. Value of Early Cash Flows: Since IRR loves early returns, a chunk of money upfront can make it look great—even if the overall profits aren’t that different from a stock market investment.

3. Comparing IRR to Stock Market Returns:

• Real Estate IRR: Those early returns inflate the IRR, but take a look under the hood—is the total profit (e.g., equity multiple) really that much better?

• Stock Market Return: Slow and steady wins the race here. No surprises, but no wild rides either.

Example Recap:

Let’s revisit that $50,000 real estate deal:

• In Scenario 1, you get $45,000 back in Year 1 and a little more later. IRR skyrockets to 80%.

• In Scenario 2, the returns are slower and spread over 3 years, leading to a more reasonable 25% IRR.

Meanwhile, your $50,000 in the stock market grows at 10% annually, landing at $80,500 after 5 years—nothing flashy, just consistent growth.

Teaser for Part 5:

Now that you know the importance of timing, let’s dive into how to use IRR to compare investment options. Whether you’re looking at real estate or stock market alternatives, we’ll show you how IRR can help you make informed decisions. Don’t miss Part 5, where we put theory into practice!

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Reminder:

Haven’t caught up yet? Revisit Part 3 to understand how to calculate NPV and IRR, and Part 1 and 2 for foundational concepts.