On the Grill: Searing the Essentials of IRR
Investors use many methods to evaluate potential deals. Some investors are successful solely evaluating based on price and their market knowledge. However, this method tends to become more difficult with larger investments or investments in new territories. Market leading investors tend to dive deeper into analysis by mapping out future financials. For those that prefer a more number driven approach, there are a few key return metrics. One heavily used metric is the Internal Rate of Return (IRR).
Put simply, the IRR quantifies the anticipated annual growth rate of an investment by examining its projected cash flows from acquisition to disposition, expressed as a percentage return over time. While the mathematical formula for IRR may seem intricate, its practical application is essentially the discount rate on future cash inflows(net income) needed to adjust them to a present value that equals all cash outflows(capital invested). For instance, if you invest $10,000, receive $500 for each of the next two years, and then cash-out at $15,000, the IRR/discount rate required for each payment you received to add up to that initial $10K investment is 17.64%.
While understanding the equation may be helpful to fully grasp what IRR measures, most investors use Excel to simplify their analysis. As shown in the image above, an investor can insert their projected cash flows for each year of ownership into a spreadsheet and apply the =IRR() formula to those cells. Since the IRR relies heavily on projected financials, it should always be taken with a grain of salt, especially when coming from outside sources. An investor must be certain the metric was measured with conservative and reliable predictions.
Typically falling between 5% and 25%, IRR benchmarks vary widely across different investments. Desired returns will vary based on the stability and risk of a deal. For lower-risk, stable properties, a desirable IRR might be around 8% to 12%. For investors investing in moderate-risk investments, an IRR above 15% may seem more desirable. Additionally, leveraging investments with loans rather than all-cash deals often enhances IRR by significantly reducing initial capital input while marginally impacting future cash inflows. Therefore, desirable unlevered IRRs will vary from desirable levered IRRs.
With any single return metric, there are always shortfalls. One significant oversight would be IRR's lack of consideration of stability. An investor should not simply choose one investment over another due to having a higher IRR. Since the IRR is calculated based on projected future cash flows, it may be heavily skewed due to inaccurate assumptions. Additionally, those properties with a higher risk usually require significant efforts from investors to reach those higher returns. Factors such as lease duration and tenant turnover significantly influence future income. Properties with long-term leases offer more predictable cash flows, albeit still subject to risks like unexpected tenant vacancies or unforeseen expenses.
Another consideration to note is that IRR does not account for investment size disparities. Consequently, comparisons between investments of vastly different scales may yield identical IRR outcomes. Further, the static nature of IRR calculations assumes uniform growth rates annually, a simplification that differs from real-world investment realities. Real estate investments, in particular, often exhibit variable growth rates, especially during disposition phases.
While IRR serves as a valuable metric for assessing investment viability, investors should supplement it with comprehensive risk assessments, qualitative factors, and additional return metrics. Recognizing its limitations, such as sensitivity to projected cash flow accuracy, allows for a more nuanced evaluation of potential returns in real estate and other investment domains.